For a major expensive home renovation (e.g. addition, finished basement, or new kitchen) should one pay cash or finance with a loan? Would such a loan be "good" debt?

Question

This other question is similar, but was referring to a specific renovation/repair (new flooring) that, while expensive ($1500), isn't very expensive – it's feasible to consider saving up for over a short period of time.

So, I'm curious: Imagine one wanted to do a major home renovation such as: building an addition to the home, finishing the entire basement (assume with bathroom), or redoing the entire kitchen.

In those cases, would it still make sense to save up the cash, or else take out a specific loan, additional mortgage, or borrow from a line of credit? Actually saving up the cash for a major renovation like that – easily exceeding five figures, perhaps approaching six! – could take many years, decades!, for some families.

So, if one could really use the additional space and didn't have cash on hand, would borrowing for such a renovation be considered "good" debt similar to a mortgage? Or are there still reasons to save up the cash?

Answer 1

Reasons to pay with cash

1. You don't owe anything when it is done.
2. You'll spend LESS and tend to limit yourself to what you "need" instead of getting renovation fever.

Reasons to borrow

1. Urgency (you've got a two bedroom house and kid number 6 will be born in 4 months).
2. You've researched the real estate market and by doing the renovations you can add much more value to your house than the cost of the renovation.
3. You love paying the bank money.

Things to watch out for

1. Getting into more debt total than your home is worth.
2. Getting a bad loan (typically goes together with number one).
3. Exceeding your budget with borrow money, or setting a larger budget aside than what is truly needed because it is easy to borrow more money than you could save.

Answer 2

"Good debt" is very close to an oxymoron. People say student loans are "good debt," but I beg to differ. The very same "good debt" that allowed me to get an education is the very same "bad debt" that doesn't allow me to take chances in my career - meaning, I would prefer to have a 'steady' job over starting a business. (That's my perogative, of course, but I am not willing to take that 'risk.' /endtangent

Harmanjd provided the two really good reason for using cash over borrowing. We have a tendency in this culture to find reasons to borrow. It is better for you to make a budget, based on what you want, and save up for it. Make a "dream list" for what you want, then add up the costs for everything. If that number makes your head hurt, start paring down on things you 'want.' Maybe you install just a wine cooler instead of a wine cooler and a beer tap, or vice-versa. And besides, if something comes up - you can always stop saving money for this project and deal with whatever came up and then resume saving when you're done.

Or in the case of the kitchen, maybe you do it in stages: cabinets one year, countertops the next, flooring the year after that, and then the appliances last. You don't have to do it all at once.

As someone who is working toward debt freedom, it feels nice whenever we have one less payment to budget for every month. Don't burden yourself to impress other people. Take your time, get bids for the things you can't (or won't) do yourself, and then make a decision that's best for your money.

Answer 3

The number one reason to borrow is quite simple; when you have no other choice. The primary reason to do this is when renovations or additions must be made in a timeframe that precludes you being able to save enough money to pay cash. Harmanjd's example of a kid on the way with no space to put him is a very good hypothetical. Disaster recovery is another; insurance doesn't cover everything and can sometimes be slow to pay out, and even if the payoff will rebuild the house exactly the way it was, these situations are deceptively good opportunities to improve on what you had. Since you already have to call in the contractors to demo and rebuild, the cost to do that is sunk, and the incremental cost of improvements or even additional square footage is relatively minor.

Other acceptable reasons to borrow are:

• When cost of capital is very cheap. A typical amortized HELOC is pretty expensive when paid on-schedule, but if you can pay it off very early (i.e. when you sell the home next month) or you get a good deal on the interest rate (a subsidized disaster recovery loan, perhaps; you have to be careful with these as they're not intended to turn a burnt-down hovel into a McMansion) the cost of borrowing can be acceptable even if you had cash savings for the project.

• You have other uses for the cash that can offset cost of borrowing. This generally requires the first point to be true as well, as it's a general rule that borrowing $10,000 costs you more than you would gain by investing $10,000, but there are situations in which the reverse can be true (if you have $10k in oil or major tech stocks right now, it would probably be a bad move to liquidate them for home improvements if you can get a HELOC at less than 6%).

• You can realize a net gain in home value from the reno. These situations are rare in cases of an already livable home; "flippers", which make their living on renovating homes for a profit, generally choose homes with obvious but easy-to-fix problems that depress home value because they look worse than they are. If you bought your home without any such problems, you probably paid something close to market value at the time, and so you're probably behind the curve. However, if you (or your family in the case of an estate transfer) have owned the home for a long time, long enough for things to fall WAY out of date, then you can catch up a lot of market value with one renovation, where if the home had had two or three renovations along the way a reno now wouldn't gain you as much value.

Answer 4

The reason for borrowing instead of paying cash for major renovations should be the same for the decision about whether to borrow or pay cash for the home itself. Over history, borrowing using low, tax-deductible interest while increasing your retirement contributions has always yielded higher returns than paying off mortgage principal over the long term.

You should first determine how much you need to save for retirement, factor that into your budget, then borrow as much as needed (and can afford) to live at whatever level of home you decide is important to you. Using this same logic, if interest rates are low enough, it would behoove you to refinance with cash out leveraging the cash to use as additional retirement savings.

Answer 5

Some good points were added here, but in the end its about opportunity costs of money. Let's say you could fully finance, partially finance or pay in cash. The money percentage you put down influences the interest rate (the more you put down the cheaper interest you get) you should consider the opportunity cost.

This means if you recieve a higher interest on an investment than the rate of the mortgage it makes more sense to invest and have a higher mortgage.

Answer 6

The crucial question not addressed by other answers is your ability to repay the debt.

Borrowing is always about leverage, and leverage is always about risk. In the home improvement loan case, default comes with dire consequences-- to extinguish the debt you might have to sell your home.

With a stable job, reliable income, and sufficient cash flow (and, of course, comfort that the project will yield benefits you're happy to pay for), then the clear answer is, go ahead and borrow.

But if you work in a highly cyclical industry, have very little cash saved, or for whatever other reason are uncertain about your future ability to pay, then don't borrow. Save until you are more comfortable you can handle the loan. That doesn't necessarily mean save ALL the money; just save enough that you are highly confident in your ability to pay whatever you borrow.