This guide is a primer on all of the most common ways to finance home improvements
and remodeling projects.
The Basics
Secured vs. Unsecured loans:
In general, loans can be described as secured or unsecured. An
unsecured loan is a loan in which the borrower agrees to repay the
money according to a pre-set schedule. A secured loan is the same
thing, except that if the borrower doesn't keep up with the payments,
he/she gives the lender the right to seize a particular asset and
sell it to raise the money necessary to pay off the loan.
With home improvements and remodeling, the asset pledged is usually
the house itself. The piece of paper that documents this pledge
is usually called a mortgage or a deed of trust. A single property
can be pledged in more than one loan, but when this happens, the
loans are explicitly ranked in priority. That's why you hear so
much about first mortgages and second mortgages.
There are basically three good reasons to consider secured loans:
- To borrow more money
- To get a lower interest rate
- To reduce taxes
Qualifying for a loan:
Before actually applying for a loan, talk to lenders about all
your options. Keep in mind, the lender will tend to focus on the
options they carry. This is why many people like to start with an
established mortgage broker as they usually carry many more types
of loans. Besides helping you understand your options and the various
trade-offs involved, the lender can pre-qualify you for one or more
loans. Because they are familiar with the lending rules, they can
tell you up front what the likely response to your application will
be.
Lenders are usually concerned about four issues:
- Income
- Debts
- Credit history
- Property value
Points and interest rates:
Many loans involve something called points. Points are nothing
more than a fee for the loan that is expressed as a percentage of
the loan amount. One point equals one percent. So if you take out
a loan for $100,000 and the lender charges two points, the fee costs
you 2% of $100,000 or $2000. Points exist so the lender can pay
for the loan set-up expenses, as well as, make a profit.
Variable vs. fixed interest rates:
For some loans, the interest rate stays the same throughout the
loan. This is known as a fixed rate loan. On other loans the interest
rate can rise or fall as market conditions change. These "variable"
rates are usually tied to some common market wide interest rate
like the prime rate. The prime rate is a well-known rate that represents
the rate that big banks charge their best big business customers.
A variable rate loan might be described as being set at "prime plus
two" which means the rate will always be two percentage points higher
than whatever the current prime rate is.
The Institutions
Selecting a lender:
There are three kinds of institutions that can help:
- Mortgage brokers
- Banks
- Specialized lenders
Mortgage brokers typically represent a number of money sources
including regional and national banks, specialized lenders, insurance
companies and even wealthy individuals. This diversity is their
greatest strength. It means that they are likely to offer a wide
number of options.
Working with bankers is another very popular way to get loans.
If you have a good personal relationship with the lender and the
lender offers a wide variety of loans, this can be a great route
to go. If you don't already have a strong relationship with your
banker, yet you are confident about getting the loan, this can be
a good opportunity to start up that relationship.
Specialized lenders come in all shapes and sizes. These are generally
lenders who specialize in one or two specific types of loans. There
strength is that they are very knowledgeable about the options they
work with and may have streamlined the processing to the point where
they can offer very competitive rates. However, don't count on specialized
lenders to introduce you to a wide range of options.
Specific financing options:
Savings:
Many people prefer to save up the entire amount they need before
undertaking a major home improvement or remodeling project. While,
on the surface, this may seem to be a prudent approach, it does
suffer from two significant shortcomings.
First of all, it means substantially deferring the actual improvement.
If the change will really increase the livability of your home,
do you really want to wait several years to save the funds?
If you already have the funds, would you be better off keeping
them in reserve for emergencies rather than spending them all at
once? More importantly, you have to look at the returns you can
get on that money.
Credit cards:
The main advantage of using credit cards or the cash advance checks
that are often associated with them is that there is no hassle at
all. You simply write a check and you've initiated a loan. Of course,
the main drawback is that the loan is unsecured and therefore, carries
a hefty interest rate that can be more than double the going rate
for a first mortgage.
Cash-out refinance:
If you have enough equity, or if interest rates are lower now
than when you first borrowed the money, this can be an ideal financing
vehicle. You are basically taking two steps at once. First, you
are refinancing your existing mortgage loan. If interest rates are
lower than when you first financed, the savings can be considerable.
Home equity line of credit:
A home equity line of credit is probably the most popular way
to finance a major home improvement. It is secured by your home,
which means that the interest is tax deductible. In addition, it
is relatively risk free for banks, so the interest rate is usually
about 1.5% higher than a first mortgage. Closing costs and paper
work tend to be much less than what's involved with first mortgages.
Home equity loans:
Very similar to home equity lines of credit, home equity loans
are also very popular. There are three main differences. First of
all, you can only borrow once and for a preset amount. Second, your
payments and the interest rate are usually fixed. Finally, closing
costs are generally higher than home equity lines of credit with
one or two points being quite common. Basically, when compared to
a home equity line of credit, you trade flexibility and higher closing
costs for certainty about what your payments will be and how long
they will go on.
Homeowner loans:
Like credit card loans, these are relatively low hassle loans.
They can be for sums as high as $25,000. They are secured by the
property, so the interest is tax deductible. However, the loan isn't
limited as much by the equity in your home the way most loans are.
They are primarily granted on the basis of income. So if you have
high income but little equity in your home, this can be a good way
to go. Because it is riskier than standard first or second mortgages,
lenders usually charge about 3% more than they would for a standard
first mortgage. The higher interest rate you pay is somewhat offset
by lower closing costs, because there is no need for a formal appraisal
and the paperwork is generally simpler to process.
Value added loans:
This is a relatively new and increasingly popular type of loan.
It basically applies to situations where the improvements you make
will have a very substantial impact on the market value of the home.
This may be true if the home is quite small or outdated relative
to its neighbors.
The way it works is that instead of lending you 80% of the value
of the home as it exists today, the lender loans you 80% of the
value of the home as it will be valued when the improvements are
complete. Typically, these types of loans carry very competitive
interest rates that can be quite close to first mortgage rates.
In order to protect you and the lender, the funds are usually released
in a series of payments called draws that occur as specific stages
of the job are completed.
Contractor financing:
Often, when a contractor offers financing, he is simply using
an established relationship with a lender to expedite the processing
of your loan. In such cases, you will still be facing the same array
of options you see described in this guide. However, there are a
few firms that directly provide financing. This is most common with
activities like replacing windows, installing siding, or putting
in a swimming pool.
Summary
Homeowners have more options than ever for financing home improvements.
While many projects add significantly to the value of the home,
the primary reason for undertaking home improvements should be to
enhance your day-to-day living.
