How to: Finance a renovation
Great if you have it, especially for small projects. But if you have a substantial sum in a high-interest investment account or mutual fund, withdrawing it in order to finance a renovation may not always be in your best interest. You should measure the loss in compound interest that the money would have earned if you left it in the bank, plus any penalties for early withdrawal, against the cost of an equivalent loan. In some cases, a loan might actually be cheaper.
There are pros and cons to financing with plastic. On the plus side, you can pay off as much or as little as you like each month without penalty (sometimes, but not always, above a nominal minimum), and if you have an existing card with a high enough credit limit, you can skip the hassle of waiting for a loan approval. It’s also a convenient way to buy what you need at retail stores and to keep track of your spending. However, there’s a price for all that convenience: interest rates are generally much higher than with other types of loans and a maxed-out credit card carries a range of problems, from a lowered credit rating to the beginning of a debilitating debt spiral. Some banks offer “secured” credit cards with lower interest rates, but for larger amounts, you still may be better off with a conventional loan or line of credit.
A bank loan is the most straightforward way to finance a renovation, or any item that requires a large initial outlay of cash. Fixed repayments are withdrawn from your bank account at regular intervals, such as weekly, biweekly or monthly. If your budget allows, try to arrange weekly payments. Since the repayment total equals the sum of the original loan (or “principal”) and accrued interest, over time weekly payments can reduce this amount much more quickly than a single monthly payment, without costing you a penny more.(Unsecured) Personal Line of Credit
These popular lending vehicles have flexible repayment terms and fixed or variable interest rates, making them useful for projects where you’ll be paying as-you-go or in installments. PLCs allow you to borrow up to a prearranged limit and pay off all or a portion of the balance each month above a minimum (which is usually fairly small).
Secured Line of Credit, Home Equity Loan
Similar to loans and PLCs, but with lower interest rates, since the equity in your home (i.e., its total value less the cost of your mortgage) is used as collateral or security. This can be a great low-cost source of funds, but it’s really a type of second mortgage, with all the drawbacks that entails, including the possibility of foreclosure if you default.
Refinancing your existing mortgage allows you to spread the payments over a much longer period of time, usually at a lower rate even than a secured PLC, and gives you access to as much as 80% of your home’s appraised value. Costs may include legal and appraisal fees, and sometimes penalties, which you should weigh against the cost of other borrowing options. Another option is to allow extra funds for renovations when you take out a new mortgage, such as when you purchase a new home.
Financial advisors generally advise against these mortgages, as they are really nothing more than highly restrictive regular mortgages that you don’t make payments on, so interest on them compounds unhindered -- to the advantage of the lender. If you want to borrow against your home’s equity, you’re probably better off with a new mortgage, home equity loan or secured line of credit.
Sources: David Potter, Potter & Partners Inc., Toronto; CMHC.