Choosing the Right Mortgage to Remodel

Paying for a remodeling project with a home loan is usually a good idea. But choosing exactly the right type of mortgage instrument may require some planning and calculation.

One of the smartest ways to use a mortgage is to pay for a remodel, upgrade, room addition, or repair to your home. By borrowing against the equity in your property to enhance its value, you essentially grow equity without any out-of-pocket expense. The key to success is to choose your loan carefully.

Refinance or second mortgage

Depending upon how much interest you're paying on your first mortgage, you may or may not want to refinance it to fund the project. If the existing mortgage has a cheaper rate than you can get today, hold on to it, and use a second mortgage to pay for the remodel. Pay off the second mortgage-and the higher interest-as soon as possible, to avoid paying steep finance charges.

On the other hand, if your existing loan is an adjustable-rate mortgage (ARM), interest-only loan, or other variety where the interest rate rises, you might be wise to refinance to a less volatile and conventional fixed-rate mortgage (FRM). Roll your remodeling costs into the new loan, and capture a better rate for your mortgage as well as your remodeling project.

Planning for a sale

If you're fixing up your place in order to sell it within the next three to five years, you won't be around long enough to reap the long-term benefits of a 30-year FRM. For the sake of argument, if you plan to remodel this year, and sell it a year from now, you might as well get the cheapest loan available. Consider an ARM with a low 2-year introductory rate. You'll save money, because you'll have already paid it off by selling your home before the loan resets to a higher rate.

Borrow based on cash flow

If you're paying your contractors or suppliers in phases, you don't need a large lump sum up front. A home equity line of credit (HELOC), which works like a credit card and lets you withdraw only when you need the cash, may be your best option. You may pay slightly higher interest, but you won't pay anything until you actually use the money. This could cost less overall than if you took out a loan in the beginning and paid interest for the entire length of the project.

Ultimately, don't forget to stick to your plan. One of the most common and costly mistakes homeowners make is that they keep expanding the original project. Soon it grows out of proportion, and the budget overruns totally offset any smart strategies that they had regarding borrowing the money with a lower interest rate.