Financing a Major Remodeling Project
Finding the money to pay for your dream project can be a daunting prospect. Here's a list of options.
Cash If you have a savings account large enough to pay cash, it's certainly the simplest payment option; there are no forms to fill out, no appraisals to undergo, and no waiting for approvals. The one drawback is that the money you spend could otherwise be earning interest in an investment. Financing your project and putting your cash into a higher-return investment might actually cost you less in the long run. Moreover, most home improvement loans are tax-deductible, whereas a remodeling project paid for in cash is not. Check with a financial adviser to see if this is a viable option.
Home Improvement Loan The Federal Housing Administration (FHA) offers two special loans for home improvements. The Title I loan lets you borrow up to $25,000 for a single-family dwelling at a fixed rate that the FHA insures against risk of default. You must go through an approved Title I lender.
The Section 203(k) loan is an option if you purchase a fixer-upper; you can receive a single, long-term, fixed or adjustable rate loan for the acquisition and the rehabilitation of the property. You must go through an FHA-approved lending institution for this loan.
Home Equity Line of Credit This option is a form of revolving credit, for which your home acts as the collateral. The line of obtainable monies is typically set at 75 to 80 percent of the appraised value of your house, less the balance of your mortgage; your credit history and ability to pay will also be considered in the amount of credit available. Usually, the line of credit will have a variable interest rate (typically a margin added to the current prime rate); you'll also incur costs when you set up the loan.
Once you've set up the line of credit, you can tap into these funds whenever you want. However, if you are new to your home, you may have very little actual equity built up. Moreover, the temptation to overuse a line of credit -- like credit cards -- can be difficult for some homeowners to avoid.
Home Equity Loan (or Second Mortgage) This is typically a fixed-rate, fixed-term loan based on the equity of your home, which you pay back in monthly installments just as you do your primary mortgage. Most lending institutions offer loans for up to 80 percent of the appraised value of your house, but some may go as high as 100 percent (though they will charge a higher interest rate). The balance of your primary mortgage, your credit history, and your ability to repay the loan will factor into the equation.
Cash-out Refinancing This is a terrific option if you've owned your home for a while, particularly if you purchased it at a high interest rate and current interest rates are lower. You would need to have your house appraised and undergo a new loan process, which would let you pay off your remaining mortgage. The remaining funds could then be used to finance your project. If you're planning on moving in a year or two, this may not be the most sensible alternative.
Regardless of how you finance your remodeling project, one excellent piece of advice is to stay within your budget. The best way is to figure out how much you can afford to spend, then allot 80 percent of that sum to your project. Save the additional 20 percent for contingencies, such as unforeseen problems that arise during remodeling.
If you're considering a loan to pay for your remodeling, here are some things to know.
Are You Eligible? Assuming you have a good credit history, most lenders follow the "28-36" rule in determining how much they'll let you borrow. The 28 means that your total monthly housing costs -- your loan payment plus the monthly share of your property taxes and hazard insurance -- shouldn't exceed 28 percent of your gross monthly income.
The 36 means that your total monthly payments for housing and other debts -- credits cards, car loans, alimony -- shouldn't exceed 36 percent of your gross monthly income.
If you and your spouse gross $6,000 a month, for example, your housing costs shouldn't exceed $1,680, and your total monthly payments for housing and other loans should be under $2,160.
Scoring Points As you shop around among competing lenders, you'll be presented with a variety of choices regarding points (also called discount points) and interest rates.
A point is simply an up-front fee the lender charges you for locking in a lower interest rate. Each point amounts to 1 percent of the total loan amount. If a bank charges you 2 points on a $10,000 loan, for example, you'll owe an extra $200 when you settle.
Usually, you're better off paying a point or two to get a lower interest rate if you're planning to stay in your house for a long time. To make sure, you can do the math. Let's say you want to borrow $20,000 over 15 years and can't decide between a rate of 8 percent with no points and 7.5 percent with 1.5 points. Your monthly payment at the higher rate would be $191, $185 at the lower rate. Divide $300 (the cost of 1.5 points) by $6 (the different in monthly payments), and you get 50. This tells you that the lower rate makes sense if you play to own your house for 50 months or longer. Otherwise, opt for the higher rate.