Planning a Remodel? Your Loan Options
Home equity has reappeared as an option for many homeowners; as such, remodeling projects have a green light. Maybe you’re thinking about renovating the kitchen, adding on a bathroom, how about replacing the roof? All of these and other improvements tend to be costly. So what’s the best way to finance these projects? Here’s a quick breakdown to selecting the right remodeling vehicle for you, from the lowest cost to highest cost options.
Home Equity Line of Credit (HELOC)
A HELOC is akin to a large credit card limit, and in a sense, it’s used in the same way. You have the ability to borrow on a certain percentage of the line amount and typically have to pay that back in a term of 10 years, with the first 10 years based on an interest-only monthly payment.
From a cash flow perspective, the program is quite favorable because the monthly payment tends to be quite low. How it works is the equity line is tied to the prime rate plus a margin (the mortgage lender’s profit). The margin can be anywhere from 0.5% to 3% and higher in some cases depending on the loan-to-value ratio and your credit score. Typical equity lines are offered a prime +0.5 or prime +1. So you’re talking about a 3.75% equity line of credit that would be secured against your home — either in first position if you don’t already have a first mortgage, or in second position if you do have a first mortgage.
Pros
Extremely cheap right now, as long as interest rates remain favorable;
Takes 30 days or less to obtain;
Typically goes up to 80% loan-to-value, or combined loan-to-value if there is already a first mortgage on the property;
Payments are based on interest-only so if you make a larger payment towards principal, it will be reflected in the following month’s payment.
Cons
This is not a long-term solution in the sense that an equity line of credit is an adjustable-rate mortgage. It’s tied to the prime rate, which moves in lockstep with the Fed’s stance on monetary policy. When the Fed tightens credit, short-term rates rise, as well the rate and payment on the HELOC.
The payment is interest-only every month, meaning unless you make an extra principal prepayment, none of the monthly payment goes toward paying down the principal balance.
If you have a first mortgage that you want to refinance, the second lien holder with the equity line of credit will have to agree to subordinate to a new first mortgage. In other words, they will have to agree to stay in second position, which could derail the deal on refinancing your first.
For a second lender holding a HELOC, they will almost always charge a fee to consider re-subordinating to a new first loan.
Cashing Out a Mortgage
This option essentially involves taking out a first mortgage to pay off the current mortgage and any subsequent second mortgages in addition to borrowing enough to cover the cost of the remodeling project. To complete a cash-out refinance, most lenders require a loan-to-value of 75% and a high credit score in the neighborhood of 700 or better. Whether the new first mortgage contains a term of 30 years or 15 years, the idea would be taking on a house payment that would allow you finance the total cost of the remodeling project.
Pros
Longer-term lower cost of funds using a fixed-rate loan;
Takes 30 days or less to obtain;
Goes up to 75% loan-to-value;
Principal balance is reduced monthly by virtue of timely payments of principal and interest on an amortizing fixed rate.
Cons
Interest rate could be higher than current first mortgage rate;
May need to finance more than the cost of the project, thus paying interest on money not needed;
May not be able to get as much cash out due to 75% maximum loan-to-value.
Personal Loan
This type of loan can be obtained from a local bank or even from an online lender. Rates are anywhere from 6% to 7% with excellent credit working with a peer-to-peer online lender, and upwards of 11% if you’re working with a local bank or credit union. These loans have shorter terms because they are unsecured, and lenders want to be paid back faster. The reduced loan terms creates a higher payment, making a personal loan pricier in the shorter term.
Pros
No loan-to-value is required;
Can be paid off sooner than traditional financing;
Faster access to procuring funds.
Cons
No tax advantage;
Substantially higher rates compared to refinancing a first mortgage or obtaining a HELOC;
Higher payments on these loan types must be counted into debt-to-income ratios on future loan transactions, limiting your ability to qualify.
Because home improvement project costs, especially larger-scale construction — such as an addition of a bedroom or remodeling of the bathroom — tend to vary, it’s always ideal to try to get more funds than necessary to account for variances that inevitably arise. With all of the three financing types laid out, if the additional funds are not needed, they can be reinvested back into the principal balance of the debt. However, of the three loan options, this approach would only reduce the HELOC payments. The other two options are based on principal and interest amortizing loans where the payment would remain constant, despite the additional principal reduction.
As you’re considering your loan options, it’s always a good idea to be informed and know what your credit score is, so you know approximately what kind of rate you’ll get. You might find that you want to take more time to build your credit in order to get a better rate on your loan. There are free online tools that allow you to check your credit score, such as Credit.com’s Credit Report Card, which also gives you a breakdown of your credit profile to show you what areas you need to work on in order to get a better credit score.
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