Footing the Bills

Consider this advice on where to obtain money in order to pay for your remodeling project.

Photo: Flickr

If you have the cash on hand to pay for your remodeling project, you needn’t read this section. Most people, however, need to borrow money to underwrite their job.

The best option is usually a mortgage loan. That’s because the interest on a home mortgage is tax deductible. There are several varieties of mortgages that can provide the funds for a home renovation project, but each depends upon how much equity you have. Equity is the net value of your property after all indebtedness held against it has been deducted from its gross value. Allow me to translate.

Suppose you want to borrow $25,000 to improve your $100,000 home. If your original down payment was, say, 25 per­cent of the purchase price, and your pay-down on the principal since then equals another 25 percent, you own the remaining 50 percent, or half your house. That would mean you are an excellent candidate for that loan, since most banks will loan up to 75 percent of the value of an existing house.

There are a number of ways you can draw upon that equity. The two princi­pal ones are first mortgages and second mortgages.

FIRST MORTGAGES
For the home renovator, negotiating a new first mortgage is one way of underwriting the remodeling job. In practical terms, this means you will apply to the bank for an all-new mortgage. If the bank approves the loan, some of the proceeds will be used to pay off the existing mortgage. After deducting closing expenses and fees, whatever is left over will be paid to you. Typically, a new mortgage makes especially good sense when the interest rate you are paying is at least one percentage point higher than the rate you would be paying on a new mortgage.

SECOND MORTGAGES
A second mortgage is exactly what its name suggests: it’s an additional mortgage to the first mortgage you are carrying. Typically the holder of the second mortgage will have a claim on the property in the event you fail to make your payments. At the time a house was initially purchased, the seller may have agreed to hold a second mortgage, but for the homeowner planning a renovation, the most likely source of a second mortgage is a lending institution.

CLOSING COSTS
Costs vary from one state to another and from bank to bank, but the costs may include lawyer’s fees (possibly yours and the bank’s); recording fees; mortgage, transfer, or other taxes; points on the loan (fees calculated as percentage points of the sum being borrowed, meaning two points on a $100,000 loan would rep­resent a fee of $2,000); title insurance; filing fees; application fees; appraisal expenses; the cost of a credit report; and so on.

With a traditional mortgage, all of these expenses are usually borne by the borrower; with an equity loan, the bank pays for many of them. When you apply for a loan, most banks routinely provide an estimate of the total closing costs. Ask for a breakdown if one isn’t offered.

OTHER OPTIONS
In addition to mortgages, there are other loan options that might suit your particular financial circumstances.

Credit card advances
If your renovation will be modest in cost, you may want to avoid the paperwork and expense of loan applications and simply draw a cash advance from one or more of your credit cards. Keep in mind, however, that the inter­est rates are generally rather high (often more than twice that of mortgages).

Personal loan
A personal loan is a relatively simple transaction. You file an application with a lender, he checks your credit and indebtedness, and he approves or disapproves the application. The loan is not secured by your home, and the decision to approve (or disapprove) the loan is made on the basis of your credit rating, income, and an overall assessment of your financial health. The rate will typically be a good deal higher than for a mortgage; the term shorter; and the interest is not tax deductible. Given these disadvantages, a personal loan should be well down your list of options.

Balloon mortgage
A balloon mortgage is one in which a large or “balloon” payment of the remaining principal is due at a specific date. Payments are made along the way, often of Interest alone though In some cases token principal payments are made as well. Balloon mortgages are more common in real estate transactions for commercial or multifamily dwellings. 

However, if your home renovation involves more than simply enlarging or remodeling your home for your family—if, say, your improvement includes the addition of an apartment or a commercial office space you expect will produce income and you’re planning to sell the whole complex within a few years—a balloon mortgage may make sense.

Construction loan
In order to construct an all-new house, few banks will issue a standard mortgage. Instead, the bank will grant a construction loan that, after the house is completed and the certificate of occupancy granted, will be converted to a more traditional first mortgage.
A construction loan works like this. When a bank approves a loan, there will be a specific disbursement schedule that specifies that a certain percentage of the loan proceeds are due upon completion of the new foundation, more upon the roof being finished, more at the time the windows are put in place, and so on. You construct your addition, and the bank pays you according to the schedule when they see that its strictures have been met.

In most cases, a construction loan isn’t the best route for a home renovator. However, if you are radically remodeling the house and the cost of the construction is substantially greater than the equity you have in the house, a combination construction loan and mortgage may be your best strategy.

Credit unions
If you’re a member of, or are eligible for membership in, a credit union, it may be another source of funds. Most credit unions are not-for-profit institutions that exist to serve their members, both helping to save and to borrow money. Inquire of the loan officer or manager at the credit union about the rates, terms, and other details. Often credit unions loan money to members at very favorable terms and with less paperwork than the same transaction would require at a traditional bank. The interest, however, will not be tax deductible.

WHICH LOAN IS THE RIGHT LOAN?
The right loan is the one that best suits your particular financial circumstances. In most cases, the key determinations are these: Does this provide enough money to do the job? and Can we afford the monthly payment?

If you have little experience in these financial matters, seek the counsel of such professionals as your attorney, accountant, or the real estate broker who handled the purchase of your house. Your banker can also help.

When the time comes to apply for a loan, do it in person. If possible, talk to the person who approves the loans or who screens them, and try to get a sense of how helpful he or she is inclined to be. Make sure you get all the attachments and instructions and a clear understanding of the processes of approval and payment.

Another suggestion? After you’ve talked with your banker and identified what you think is the best strategy, sleep on it. Have a couple of additional conversations, perhaps with your lawyer or a close friend whose business acumen you trust. To borrow money is to assume large and often long-term responsibilities and shouldn’t be done casually