Financing Your Home Project
Whether your home remodeling project is large or small, most times the cost of remodeling or building will be a substantial—especially in comparison to other household expenses. When you start planning a remodeling project, you should start early thinking about how you’ll finance the project. The scale of the project that you can undertake will be directly influenced by the amount of money available. Maybe, as we discussed in our blog on Master Planning and Feasibility studies, if your remodeling plans are ambitious or expensive, you’ll want to consider having your remodeling done in phases–perhaps over a period of years, as the money is available. When you go to a design/build firm, one the first questions they’ll ask you is “what is your budget?”
Fortunately there are several options you have for obtaining financing. The four primary options are 1) cash; 2) a Home Equity Line of Credit; 3) Cash-Out Refinancing and 4) a Loan-to-Future Value loan, which is really a construction loan wrapped into re-financing. If your remodeling plans are ambitious or extensive, you’ll want to consider having your remodeling done in phases—perhaps over a period of years, as the money is available. When you go to a design/build firm, one of the first questions they’ll ask you is “what is your budget?”
Cash is terrific if you have the money available to you through personal savings, inheritance, or from another source. But even when you have the cash available, it’s still worth considering a couple of points before deciding this is the best option. Interest payments on a home improvement project are tax deductible, but the cost of a remodeling project paid for in cash is not. If you are borrowing money for 3 ½% and are in the 28-33% tax bracket, you are probably paying only about 2 ½%. A second consideration before deciding to pay cash is whether you might have other needs for the cash or whether you could be earning more on your money through another investment with a higher yield.
Home Equity Line Of Credit
A home equity line of credit is a form of revolving credit in which your home serves as the collateral. They are sometimes called second mortgages and they usually don’t involve closing costs. The amount of equity that you have in your home—the difference between the current appraised value of the home minus the amount owed—plays a big part in the bank’s decision on the amount approved for your line of credit. Like other loans, a line of credit has a term—an agreed upon period of time—that the lender will make that set amount of money available. The borrower is not advanced the entire amount up front, but uses a line of credit to borrow sums over time that total no more than the maximum credit limit set by the bank. For instance, if I have been approved for a $100,000 line of credit, I can draw money from this as needed.
One of the differences between a Line of Credit and other loans is the interest rate is always variable, which means that it can change over time and is usually based on an index, such as the prime rate. During the term of your loan, often the payments required are only the interest due on the loan. The entire amount of the loan is due at the end of the term—like a balloon mortgage. Usually the term of a Home Equity Line of Credit is between 5 and 25 years.
A cash-out refinance is a replacement of your first mortgage, so this option does involve new closing costs. With cash-out refinancing, you refinance your mortgage for more than you currently owe and then pocket the difference. Let’s say your home is worth $750,000 and you current mortgage is $300,000. You want to remodel your kitchen and you also need some cash for your child’s tuition, so you’ve decided you need $100,000 for both. With cash-out refinancing you would refinance your mortgage for $400,000, taking the additional $100,000 out in cash and hopefully, especially in the current economic times, borrow the money at a lower interest rate than your original loan.
In deciding between a cash-out refinance and a home equity line of credit, you should consider the cost of refinancing your home. The closing costs are usually several thousand dollars. And, it doesn’t make sense to finance a larger amount, if the interest rate is higher. If your current mortgage is at a lower rate than currently available, it probably makes more sense to take out a home equity loan.
Loan To Future Value, or Future Value Financing
A loan to future value involves making projections about the future worth of a property after improvements and adjusting the financing arrangement accordingly. Many homeowners use construction-to-permanent (or loan to future value) financing programs where the construction loan is converted to a mortgage loan after the certificate of occupancy is issued. If a homeowner wants to make improvement to a property and needs money to finance them, the lender will evaluate the impact of these changes on the value of the land and buildings involved. The extension of the mortgage will be based on whether the lender determines that the amount of the loan will result in a rise in value of the property that is at least comparable to the amount of the loan, including interest and fees.
Once you have a schematic design and a preliminary construction estimate, then you can lock-in the loan amount and interest rate. The bank will pre-approve you for a loan and it is possible to purchase a rate-lock agreement valid through the expected completion of construction. You only pay interest on the construction loan as make draws. You, the contractor and the lender establish a schedule for draws based on stages of construction. Construction loans are usually variable-rate loans priced at a spread to the prime rate or other short-term interest rates. The full amount of the construction loan is due on completion of construction. The property is refinanced on completion of construction. So, the borrower pays two rates—one for the construction loan and one for the mortgage. During construction, the bank will send an inspector out to check the project at every stage of construction. There are fees for these inspections—usually in the range of $50.00 per inspection, that are paid for by the borrower.
The major advantage of this type of loan is that you only have to make one application and have one closing and you can borrow more than would be available to you with a conventional refinance.
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