How to Finance a Home Improvement Project
Story by Gretchen Wieman
A new bathroom, an updated kitchen, a finished basement – so many remodeling project choices! Fortunately, there are also many ways to pay for that home makeover
Have you ever looked at your kitchen and mentally screamed: "I need more space!" or "A new window would change this entire room!" I know I have. As a longtime reader of shelter magazines, I often wonder: "Who are these people and how can they possibly afford these amazing renovations? They can't all be fabulously wealthy." And the truth is, they're not.
Homeowners often need some money to help get the job done. There are a number of financing options available to make that dream a reality, but it's important to be thoughtful and deliberate before making any final decisions.
"A remodel or addition is a great way to maintain and/or increase the value of your home," says Dan McCue, a senior vice president for Alaska USA Federal Credit Union. But before getting started, he suggests preparing a budget (maximum amount you are willing to spend) and determining how you plan to pay for the work (cash or loan). Add in a little extra – cost overruns are very common. If you need a loan to pay for the remodeling, research the options in the market that meet your needs and monthly budget requirements.
Once you've figured out the details of your project and are ready to look at financing, Sue Benedetti, vice president for First National Bank Alaska's Home Loan Center, encourages homeowners to "sit down with your loan originator and go over the programs for which you qualify and that meet your financial situation."
Here are some financing options for you to consider:
Home Equity Loans: When it comes to paying for your addition or remodel, one of the best financing options is a home equity loan. This is a loan against the equity you have in your home. Typically these loans have fixed interest rates. This is a better option for someone who wants to lock in a fixed interest rate, either because they think interest rates are going to increase or because they like the certainty of knowing what their payment schedule will be. Interest rates for home equity loans are often higher than mortgages, but because they're usually for a shorter term the total cost of the loan including interest is less. The interest you pay on the first $100,000 of your home equity loan may be tax-deductible.
On the downside, if you already have a first mortgage, you will end up with two separate payments.
If you're going to do a one-shot, straightforward project such as building a deck, which will be paid upon completion of the project, the home equity loan is probably the way to go. You'll be able to budget a fixed monthly payment until the loan is paid off. But if you have an open-ended project, a home equity line of credit (HELOC) is the most flexible option.
Home Equity Line of Credit: A HELOC is like a credit card that you use to access the money in your equity credit line. Unlike home equity loans, they offer revolving credit – you pay on the amount you've withdrawn. It is a definite advantage if your home improvements bring unexpected expenses down the line, or for jobs where you pay out large sums in stages.
The credit line is usually set at 75 to 80 percent of the appraised value of your home minus the balance of the first mortgage.
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 period during which you must repay, typically 10 to 15 years.
One drawback: When rates go up, so do the monthly payments.
Construction Loans: Most people think construction loans are for new construction, not remodeling. However, if you find a home that needs major remodeling, or live in one, the construction loan is an excellent choice. 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 your 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. The construction loan is based on the future value of the property once the remodel is completed, not the present value. Even if you do not have enough equity in your home to get a home equity loan, you can often still get a construction loan.
Because these loans aren't typically backed by substantial equity, they do carry higher interest rates than home equity loans. The interest rates are variable: If rates go up, so do payments. After the project is completed, you must refinance your home, based on the new appraised value of the home.
FHA Title 1 Loans: This type of loan, insured by the federal government, does not require any equity in your property to qualify. The loan can be used to finance repairs or renovations that help improve the usefulness or livability of the home. The home improvement project can be as small as adding some extra insulation to the attic to larger home projects such as replacing a roof, remodeling a kitchen, adding a bathroom, buying a new furnace or constructing a new room on your house. The loans must be used to pay for structural or site changes, repairs or additions and cannot be used for luxury or extraneous items like hot tubs, barbecue pits or interior decorating.
The improvements must also be part of the permanent structure and cannot be temporary in nature. It has a loan limit of up to $25,000 with a maximum loan term of 20 years. The interest rate on these loans can vary from one location to another and even from one lender to another, so shop around.
401(k) Loans: Your employer might let you borrow from your 401(k) plan. Most 401(k) retirement plans allow participants to withdraw loans for five years with no tax implications. Some policies allow you to withdraw the money for any reason, while others limit loans to healthcare emergencies, to pay for education or for purchasing a home or making home improvements.
While borrowing from yourself may seem like a wise money move, financial advisers uniformly denounce the idea. Even though you are paying yourself back with interest, you miss the chance to compound that money over the five years it is out of your account. Note, too, that you must pay off the loan almost immediately if you leave your job, voluntarily or otherwise. If you can't repay it, you get hit with an additional 10 percent early withdrawal penalty.
Once your financing is in place and you have your contractor lined up, you're ready to go. It's time to turn your daydream into a home that you really love.