1. Take out a home equity loan
Also known as a second mortgage, home equity loans are made against the value of your home. The bank uses the equity in your home as collateral and puts a lien on your home. Interest rates, normally fixed, are often higher than on a first mortgage. Fees and closing costs are relatively high, too, although they are lower than with a refinanced mortgage. Fees and closing costs, too, are relatively high compared with other options.
One drawback is an 80 percent loan-to-value ratio. If your house is worth $250,000 and you owe $190,000 on your first mortgage, you could borrow just $10,000 before hitting that cap. If you want to make $40,000 in upgrades, you would have to go with either a higher-interest loan or look for another option. Yet the interest you pay on the first $100,000 of your home equity loan may be tax deductible. (To be tax deductible, the IRS says you need to use the money exclusively to pay for home improvements, and you must itemize.)
Home equity loans work best for amounts you consider medium to large and that require more than 10 years to pay back. They also typically don't carry a prepayment penalty, so if you get a bonus or other windfall, you usually can pay it back early.
2. Consider a home equity line of credit
A home equity line of credit (HELOC) is a cross between a home equity loan and a credit card. In fact, many banks give you a credit card which you then use to access the money in your equity line. Like a home equity loan, the interest on the first $100,000 you borrow may be tax deductible.
The bank sets a "draw" period during which you can take money from the line, usually between five and 10 years, and another span during which you must repay, typically 10 to 15 years. HELOCs allow you to repay your loan and then borrow again as you need it during the draw period. The bank only charges closing costs once, upon opening the line. During your draw period you pay back only accrued interest. After the draw period ends, you must repay both principle and interest. The primary drawback of a HELOC is that the borrower is at the mercy of interest rate movements. When rates go up, so do the monthly payments. The option to pay interest only, though, may tempt some borrowers to take on more risk.
A HELOC makes sense for short- to mid-term loans and especially when you need to withdraw money over a span of many months. They also make sense if you believe interest rates will fall over the next year or two.
3. Refinance your existing mortgage
Home values in some real estate markets have doubled during the past few years, inspiring homeowners to take on big renovations. Because mortgages are paid over 15, 30 and in some cases 40 years, monthly payments are spread over a much longer period and are thus lower than a shorter-term HELOC or a home equity loan. And since your home is used as collateral, interest rates are typically some of the lowest you can find.
Lower interest rates and lower monthly payments might make a larger project possible, but they also mean you will be paying interest longer and thus the financing will cost you more in the long run. The biggest danger with a refinance is when real estate values fall. If you borrowed against the full value of your home and prices fall in your area, you may end up with a more expensive loan than your home is worth.
4. A construction loan can be a short-term fix
If you don’t have enough equity in your home to cover a renovation, a construction loan may be a good bridge. With a construction loan, you tell the lender what work you plan to do on the house and they decide how much that might increase the value of their house. Based on that increase, the lender approves the money to get it done. Construction loans are meant as short-term options and only last as long as the work on your home is ongoing. After construction is over, you must refinance with a home equity loan, a HELOC or a new first mortgage.
Construction loans offer variable interest rates. If rates go up, so do payments. You, the bank and your contractor agree to a schedule that the bank will use to issue payments, either directly to you or your contractor. Construction loans also offer an added level of protection for homeowners because banks typically require several steps to protect their interests. A construction loan is a great option and, especially if you are doing a major remodel. The good news is the bank will require a release of liens from subcontractors and will protect you from other common traps before they issue the final payment to your builder, giving you additional protection.
Because they aren't typically backed by substantial equity, construction loans do carry higher interest rates. On the bright side, some construction loans can automatically convert to a longer-term loan, (called a One-Time-Close) meaning you only have to pay closing costs once. Watch the rates on these though. It can be beneficial to do a construction loan and then refinance the construction loan with a final mortgage, even if you are paying closing costs twice. The end rate can be substantially lower with the two loans rather than the One-Time-Close product.
5. Pay from savings if you can manage it
If you have the luxury of a having substantial personal savings account, tapping that nest egg might (or might not) be a good way to cover the cost of your renovations. The deciding factor should be where you are keeping that money and how much interest it earns vs. the cost of interest for a loan after factoring in the tax deduction.
First, consider the cost of borrowing money. Should the cost be, for example, 8 percent, and you are able to itemize and deduct the first $100,000; the net cost, if you are in the 25 percent bracket, is 6 percent. What you need to then look at is, is my cash earning me more than a net 6 percent? Assuming you have a sufficient emergency fund and enough cash on hand to handle your monthly expenses, paying cash can be a good idea. If you can earn more than 6 percent after tax, investing and then borrowing the money to cover your renovations would be the obvious good thing to do.
The reality of most borrowers is that their cash is not earning 6 percent. When it comes down to it, if you can pay out of savings, that is usually the cheapest money you are going to find. Borrowing money always costs you something, and if you are only earning 1 percent on your savings account, it doesn't make a lot of financial sense to borrow it at the much higher rate… if you have the savings available.
6. A hybrid savings-equity loan can be tricky but effective
If your savings are earning a healthy return, there is a way to let that money continue to work while using it to finance a renovation. By setting yourself up with an investment account earning an interest rate higher than the loan, you can set up an automatic draft from that investment account to make the loan payments. The savings pays off the loan and has the potential of earning a surplus for the borrower.
This method sounds neat, but the drawback is that you are subject to the investment market. Remember, with any investment you are taking a risk. The danger is a loss on your investment portfolio and a loan that still needs to be paid off. That said, over 10 years your gains and losses would more than likely average out. Something to consider.
7. You have no equity? Time for a personal loan or line of credit
If you don’t have enough equity in your home but have good or excellent credit, taking a personal loan or line of credit may be the way to go. They typically carry higher interest rates, but if the proceeds pay for home improvements that increase the value of your home, it's possible to get an appraisal after the work and refinance the loan at a lower interest rate.
The drawback is that you would have to pay closing costs on both loans, driving up your costs. There's also the risk that the housing market can’t support a higher appraisal, making it harder to refinance. On the bright side, if you are careful with your record-keeping, you might be able to deduct the interest from a personal loan following the same guidelines as a home equity loan or HELOC. The only thing there is that you need to demonstrate that it was used to remodel and would have to keep good records to prove it was. That is an issue to confirm with your accountant.
See you in a few days with our final chapter..........................
Comments