Remodeling With a Home Equity Loan – Six Things to Remember
Imagining how you're going to enjoy the new comforts of a home renovation after you've been approved for a home equity loan can be relaxing. The expanded living room, bigger bathtub, new game room or whatever else you've been dreaming of can seem like a carefree time that you'll soon be enjoying.
Problems pop up, as they often do with construction projects, and some are out of a homeowner's control. Other potential problems, however, can be dealt with before they happen by thinking ahead before getting approved for a home equity loan or line of credit. Here are six things you don't want to overlook before taking out such a loan for a remodeling project:
1 - Realize you're paying higher interest
A home equity loan is given to the borrower in a lump sum, and the interest is charged on the full amount from the beginning of the loan - which are major differences from a home equity line of credit, also called a HELOC.
Without going into all of the ins and outs of a HELOC, it's worth noting that a home equity loan is repaid at a fixed interest rate that's about 2 percent more than a HELOC. The payment is a fixe amount for a specific number of years, usually 20 to 30 years, for a home equity loan that requires at least 10 percent equity in your home.
With however much money you take upfront with such a loan, it's yours to spend as you'd like. Be smart and put the money aside in preparation for paying contractors who will be doing your home renovations.
2 - Check out the contractor
Along with getting referrals from friends and family, check out a contractor's license with state licensing agencies.
Your loan officer will likely want to check out the contractor you want to hire if you're taking out a home equity loan, though a HELOC won't require as much attention, says Trey Horton, a residential mortgage loan officer at InterLinc Mortgage Services in Birmingham, Alabama.
"They don't have to worry about anything if they take a home equity line of credit out," Horton says. "They can even do the work themselves."
3 - Check the contractor's insurance
After checking out a contractor's referrals and past work, and if they've been sued for shoddy or incomplete work, make sure they have enough general liability and worker compensation insurance.
Minimum requirements differ by state, but make sure it's enough to cover your house if it's destroyed, for example, in an accidental fire caused by the contractor or subcontractor.
At least $500,000 is a good starting point for general liability coverage, and $1 million is good for workers compensation insurance, says Stan Templeton, owner of Majestic Construction and Roofing in Oklahoma City. At the first meeting with the contractor, ask that they have their insurance agent send you a copy of their insurance certificate, Templeton says. If they won't, that's a red flag, he says.
"You don't want people on your property who aren't insured," Templeton says. "They fall down on your front step, they may sue you."
4 - Avoid liens on your property
This may be one area that you'd think would be out of a homeowner's control if subcontractors aren't paid by the general contractor and the subcontractors put a lien against your home for nonpayment - even if you've paid the contractor in full. But there are a few options, if you think about them before renovations begin.
One is to require the contractor to secure a payment bond for subcontractors before the project starts. It's a form of insurance that the contractor won't get back if it's not used, and can add $1,000 or more to the job cost, Templeton says.
Another option is to ask the contractor to set aside funds in an escrow account to pay the subcontractors, which should entice subcontractors to sign a waiver to post a lien. This option is rarely used, Templeton says, because the customer's checkbook is a sort of escrow account that doesn't get paid out until certain work benchmarks are met.
Templeton says he can give customers lien waivers that all of the subcontractors are paid in full at specific milestones and the end of a job.
A performance bond can also be requested by homeowners, requiring the work to be satisfactorily completed according to the contract terms. The bond could increase the cost of the project by 2-5 percent, but the extra expense may be worth the peace of mind, especially on large jobs.
5 - Increase your homeowner's insurance
If the renovations are expected to raise your home's value by 6-12%, it's a good idea to check with your insurer to make sure your improved home is covered in a loss, Horton says.
A family's insurance agent can also determine if the contractors have enough insurance to cover potential losses and if the homeowner's insurance should be increased. Wording in the contract with the contractor may need to be added to ensure that the contractor's insurance is the primary insurance and that they waive the right to file claims against the homeowner and the homeowner's insurance policy.
Whatever extra homeowner's insurance you get, don't wait until after the renovation to increase your coverage. Homes can burn to the ground, for example, during construction work, and extra insurance could help cover such losses.
6 - Add life insurance
Life insurance may be the last thing you're thinking about before you remodel your home, but it's something to consider when adding to the value of your home and taking out a home equity loan. Adding more debt to your life is a good reason to check your life insurance policy and review it to make sure you have enough coverage to repay that loan if you die, says Rick Huard, senior vice president of consumer lending at TD Bank.
Home Equity Loans and Remodeling
Seeing that your home's bathroom is falling apart or that the kitchen needs remodeling is easy enough to figure out. Understanding the home improvement loan options to pay for the work can be a lot trickier.
Two common ways to finance home improvements are a home equity loan, and a home equity line of credit, also called a HELOC. Both require having some equity in your home, usually at least 10 percent.
In the end, you'll get an improved bathroom, kitchen or other area of your home to enjoy, and the home's value may go up, though not all remodeling work pays for itself by increasing a home's value.
"There is some value in updating a home for your own use," says Wendy Cutrufelli, sales and marketing administrator for the mortgage division of Bank of the West in San Francisco.
Here are some basics on how the line of credit and loan options work:
This is the most popular choice for remodeling a home, partly because the interest rate is lower than a home equity loan, and because the line of credit can be used over 10 years - called the draw period - and interest is only charged on the amount taken out in that time.
This can come in handy if you expect to take a few years to remodel your home, and aren't sure exactly how much money you'll need.
Interest rates change during the length of a HELOC, and can change at intervals such as quarterly, every six months or annually, Cutrufelli says. Current rates are about 5 percent, with a home equity loan rate 2 percent higher, she says. The worst case scenario for a HELOC interest rate is to be about as high as a credit card, around 18 percent interest, she says.
After the 10-year draw period, the borrower has 20 years to repay the entire loan, though they can refinance the adjustable HELOC rate into a fixed rate loan.
A HELOC is typically the second lien position behind a first mortgage, says Peter Grabel, a mortgage loan originator at Luxury Mortgage Corp. in Stamford, CT. Depending on a borrower's credit score and loan to value, HELOCs are offered at roughly the Prime Rate (currently 3.25 percent), Grabel says.
Although the rate is tied to the Prime Rate for the life of the loan, whenever the Prime moves, the HELOC rate will move. Prime has been at an all-time low of 3.25 percent for the past five years, but has reached 12 percent in the past, and there's no cap on the rate, Grabel says.
Pay interest only to start
Only interest is required to be paid during the 10-year draw period of a HELOC, after which the principal must start being paid. However, the borrower can pay down the balance at any time, Cutrufelli says.
For example, if $100,000 is drawn from a HELOC at 5 percent interest, the monthly payment of interest only during the draw period is $417 a month, she says. But after 10 years of paying interest only, the monthly payment would increase to $1,073 for 20 years to also include the principal.
The more equity you have in your home, the better interest rate you'll get. Someone with 40 percent equity may get an interest rate that's .25 percent lower than someone with 10 percent equity.
The total debt generally can't exceed 80 percent of the market value, says Thomas Scanlon, a certified public accountant at Borgida & Co. in Manchester, CT.
Interest tax deductible
A HELOC is considered a mortgage, so the interest paid on it is tax deductible for up to $100,000 of debt. HELOCs are often repaid as a 30-year loan.
A lender only requires a borrower to state on a lending form that the HELOC is for a home improvement, and doesn't check afterward how the money is being spent. Feasibly, a homeowner could borrow from their home's equity to pay for a vacation or buy a car. Most people use it to fix their home, Cutrufelli says, though some use it to pay for a child's college.
"The great majority of them are using it for very good reasons," she says.
While HELOCs can be used to pay for a car or consolidate debt, consumers are probably better off getting other loans for those purposes, says Charles Price, vice president of lending at NEFCU, a credit union in Long Island.
"Loan rates have been so low that that doesn't make much sense now," says Price, citing low auto loans.
HELOCs also become more popular as home prices appreciate and owners gain more equity in their homes. They're also regularly used by house flippers.
"Now they're on the upswing because people are buying properties again," Cutrufelli says.
For someone with enough equity, income and good credit, HELOCs are fairly easy to obtain, Scanlon says. There's also no costs or very little to get one, though there can be fees for running a credit report, home appraisal and closing fees. Some lenders may pay those fees for the borrower.
Home equity loan
Unlike a HELOC, where a line of credit is available any time, a home equity loan amount is determined upfront and the borrower gets it as a lump sum.
The principal and interest is paid on the full amount from the beginning of the loan, at a fixed rate that's about 2 percent more than a HELOC. The interest may also be tax deductible, depending on the homeowners' tax status.
An advantage of a home equity loan is the borrower will know the fixed payment and term - usually for 20 to 30 years - that they'll be paying. It can be a good loan for someone who knows exactly how much money they'll need for the planned home improvements, Cutrufelli says.
For people who might need money for home improvements over a long period, they might be better off refinancing their current mortgage for a larger amount, Grabel says. For short-term loans, HELOCs are an inexpensive way to borrow, he says.
Factor in 15% cushion
However you pay for a home remodel, factor in 10 to 15 percent more than you intend to use in case the project comes in over budget with an unintended expense, says Anthony Pili, director of strategic planning at Greater Hudson Bank in Bardonia, N.Y.
"During home renovations, it is very hard to anticipate exactly how much it will cost to complete the entire project," Pili says.
"I've seen customers take out too little on a fixed loan at the onset of the project and then couldn't complete due to the shortfall," he says, "...as well as customers borrowing too much upfront to avoid any risk of shortfall, but then had to pay interest on funds that they did not need and had to start paying for it before the funds were deployed to various contractors."