The Wall Street Journal
FEBRUARY 25, 2011

Q. My house is more than 20 years old. I want to remodel my master bathroom and am wondering how I should pay for it. I figure it will cost about $30,000. With interest rates going up, what’s the best course of action?

–Brooklyn, N.Y.

A. There’s no one right answer to this question, so let me spell out your choices.

Paying cash for the remodeling job is, of course, the simplest solution, assuming you have enough to spare for at least six months of living expenses and won’t be raiding your retirement fund. Plus, you won’t have to pay any interest on borrowed money, so you won’t have to worry about interest rates going up.

But there are some drawbacks. First, you lose out on interest that you might have earned on the money had you invested. Second, if the project costs run beyond the anticipated budget—and they often do—you may be hard-pressed to cover the shortfall. And third, you won’t get the tax breaks you are allowed under certain circumstances if you borrow the money to improve your home.

So borrowing is your next alternative. You can do this by securing the loan with your property, through a home equity loan, line of credit or cash-out refinance. Or, you can get an unsecured personal loan supplied by your bank, your credit card company, the remodeler and/or a home improvement store.

You typically get a better interest rate if you go for a secured loan that allows you to borrow against your home’s equity.

A home equity line of credit is the most flexible option, since you can borrow only as much as you need, as you need it. However, since the interest rates are variable, you are vulnerable to interest rate spikes.

With a fixed rate, a home equity loan eliminates this problem, but you will need to specify the amount you want to borrow up front. However, if your lender allows it, you may be able to start with a home equity line of credit and later convert it to a home equity loan for a fee.

Another alternative is a cash-out refinance, where you retire your old loan and take out a new one to cover the cost you still owe on your home along with the improvements. Whether this is the best option depends on several factors. If you can get a lower rate by refinancing than you have on your current mortgage, than refinancing generally makes the most sense. But if you’re only a few years away from paying off an amortizing mortgage, then more of each payment is going towards principal than interest with each passing month. Since you’ve already paid most of the interest, it is best not to touch the original loan. In that case, a home equity loan may be better.

Before you commit to any loan that is secured by your home, make sure you’re in a solid position to pay it back. If you don’t, you can lose your home.

Getting an unsecured loan eliminates that risk, but you could pay interest rates that are double or even triple what you’d pay for a secured loan. Some remodelers and big-box stores offer a low- or no-interest period, but beware if you don’t think you can pay the loan within that time. Rates often rise steeply when the grace period ends.

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