- Kirk HaverkampApril 17, 2012 - MortgageLoan.com
Monday, Apr 16, 2012
Home improvement projects are popular these days, but getting financing for them can be difficult. So what are your options in today’s tight credit market?
The challenges and uncertainties of buying one home while selling another are pretty daunting right now. As a result, many homeowners who would otherwise be looking to move up to a larger or nicer home are opting instead to improve the one they have. Permits for home improvement projects have been trending upward even as the housing market has struggled and hit their highest level in 5 years over the winter, with 2.9 million issued in February alone.
That being said, the same tight credit that is bogging down the housing market is also a problem for homeowners looking to remodel. So where can you get financing for a home improvement project?
Fortunately, there are a number of options. While some require that you have a fair amount of equity in your home, that isn’t the case for all of them. In fact, some are even available for homeowners who are underwater on their mortgage. Here’s a look at some of the main ones.
Home equity loan
This is traditionally the first choice for financing major home improvements or remodeling projects. Basically, it involves taking out a second mortgage on your home to pay for the work you want to have done. Because it’s a type of mortgage, the interest you pay is tax-deductable, which makes this a very attractive type of financing.
Of course, to get a home equity loan, you need to have equity in your property. Most lenders will allow you to borrow against no more than 80-85 percent of your home’s current value – and that includes the balance on your existing mortgage. So naturally, this isn’t an option for those who are underwater on their mortgage or have little home equity to begin with.
Home equity line of credit (HELOC)
This is another type of home equity loan. The difference is, instead of borrowing a lump sum, you’re given a line of credit, like a credit card, that you can borrow against as you need it. This is convenient for do-it-yourself projects or others where you need to make occasional outlays for materials or labor. HELCO interest rates tend to be lower than on a regular home equity loan, but the tax advantages are the same. Equity requirements tend to be somewhat stricter than on a standard home equity loan.
With mortgage interest rates as low as they are, it might make sense to simply do a cash-out refinance of your existing mortgage rather than seek a home equity loan or HELOC. In a cash-out refinance, you borrow against the value of your home as part of refinancing your mortgage – you take money away from the transaction.
The interest rates are lower than on a HELOC or regular home equity loan, and refinancing your current mortgage lets you reduce the interest rate on your existing mortgage debt as well. You may also find that lenders are more willing to do a cash-out refinance than either type of home equity loan, although closing costs tend to be significantly more.
Again, this type of loan is available only to borrowers with significant equity in their homes.
FHA 203(k) refinance
This is the first of the home improvement loan options for borrowers limited home equity. An FHA 203(k) refinance allows you to refinance your current mortgage with an FHA loan while borrowing additional money for home improvements. The additional amount you can borrow for home improvements is based upon the improved value of the home once the work is completed. This provides a bit more flexibility for homeowners who currently don’t have much home equity.
This type of loan can’t be used for luxury improvements such as installing a hot tub, although more routine niceties such as an outdoor deck are allowed. All work must be completed within 6 months unless a waiver is obtained. This type of loan is also available to buy and rehabilitate a home as well. Contact an FHA-authorized lender for details.
FHA Title 1 home improvement loans
With this type of loan, you can borrow up to $25,000 for home improvements even if you’re underwater on your mortgage. These are fixed-rate home loans with terms of up to 20 years. Interest rates are higher than on the loans described above – 10 to 14 percent is common – but are still much lower than you would get on a unsecured personal loan from a private lender. Same as an FHA 203(k), this type of loan cannot be used for certain improvements deemed to be luxuries.
Borrow from your 401(k)
If you have a 401(k) retirement account, you can borrow against it to make home improvements. Note that we aren’t talking about taking money out of the account, but borrowing money you’ll repay to yourself. The advantage of this approach is that you can borrow money at a really low effective rate – usually slightly higher than what it would earn if left in the account (so most of the interest is paid to yourself).
The downside is that the interest on these loans isn’t tax-deductable, as on a home equity loan, and you typically have to repay it back into the account within 5 years. Also, if you’re laid off, you have to repay the loan in just two months or incur a 10 percent penalty for early withdrawal. This makes it an option you really should consider only if you have a pressing need for improvements, such as major repairs or adding necessary space for a growing family.
Borrow against other investments
Maybe you’re underwater on your mortgage, but have investments such as stocks, bonds, CDs or mutual funds? Rather than selling them to pay for the work, you can use them as collateral to take out a loan. This will get you a much lower interest rate than on an unsecured personal loan from a private lender. In cases like this, you typically want to avoid borrowing against stocks or mutual funds since the value may decline and the debt could be called in. Fixed-income investments, such as bonds or CDs, offer a more stable option.
Many types of contractors will provide their own financing for work you have them perform. This is particularly true for products and services like new windows, siding, roofing or furnaces and air conditioning systems.
If you go this route, be sure you understand what the true cost of the financing is. Some contractors may advertise low interest rates or no interest payments for a year, but charge higher rates for the work itself, so you end up paying more out of pocket than you might have with another contractor and bank financing.
Credit cards/personal loans
As a last resort, you can always put it on plastic. But don’t forget, credit cards carry some of the highest rates around. Personal loans from a bank, which like credit cards are an unsecured form of credit, also tend to carry high interest rates. Many borrowers underestimate just how long it will take them to repay a high-interest loan, particularly when it involves the type of money needed to do most home improvement projects.
Generally speaking, this type of financing should be used only for small, relatively inexpensive projects that can be quickly repaid. Credit card companies often offer low- or zero-interest “teaser” rates that may seem attractive but can get you into financial trouble if you don’t pay them off before the teaser rate expires and the rate jumps. Use with caution.