Where to Get the Money for Renovation
Before you hire a contractor, you should have the money in place for what you want to do. Be aware, though, that cost might not stay firm. You might earmark a certain amount for a job, but want to add some extras, or change something once the job is under way. Remodeling attorney Reynolds Graves says that to whatever figure they arrive at they should add 20 percent. “People almost always spend more than they plan to, and you should have the money ready.” Adds contractor Matt Mahoney of Mahoney Construction in Huntington, New York: “Improving their homes is like sex to some people. The more they get the more they want!”
The bizarre thing about loans is that very few people shop around for them. Indeed, most people spend more time shopping for a TV or toaster than for a loan. But they should. The savings can be nothing short of stupendous.
For example, if someone borrowed $100,000 and the interest rate on it was 10 percent and the term was thirty years, they would pay about $878 per month, or a little more than three times the loan, or $315,720 over the thirty years. If you pay 14 percent interest, you would pay $1185 per month, or $307 more per month than for a 10 percent loan; and over the thirty years you would pay $426,553—four times the amount of the loan, or over $110,846 more—two or three years, salary for many people!
Secured and Unsecured Loans
All loans can be characterized as secured or unsecured. A secured loan is backed up by collateral, a house for example. An unsecured loan is not. The unsecured loans are generally more costly than secured. Following is a look at various kinds.
Home Equity Loan. Here, one borrows on the equity in a house—the market value less the amount owed. For example, if $25,000 was still owed on the house and its market value was $200,000, the market value would be $175,000 and would be available. In practice, though, the amount to be lent is factored into what the homeowner is paying out, and banks usually don't want the homeowner to be paying out more than 37 percent of monthly income on car, mortgage, and the like.
The rate you pay is based on the prime interest rate. It's usually one or two points above prime, the rate banks charge their best (and usually biggest) customers. If prime were 8.25 percent, you could pay 9.25 or 10.25 percent. But this could be more—some banks charge three and four points higher and some are adjustable, the rate going up or down depending on the prime rate. It's important when shopping for this type of loan to know what the “cap” rate is—the figure above which the loan cannot rise.
Interest on the loan is also tax deductible as long as the total debt on the house is less than $1 million (not a problem for most of us). This can be significant. For example, if you had a $20,000 loan at 12 percent, the interest would be $2400 a year. However, assuming you were in the 28 percent tax bracket, the after-tax cost would be $1728—a monthly saving of $56 or $672 per year.
Balloon Payments. Some home equity loans offer so-called balloon repayments. Here, you only pay interest back over a short period of time, then the “balloon”—the principal on the loan—all at once. This is a bad idea because if you can't refinance to get the money or get it in some other way your property will be at risk of foreclosure.
Home equity loans usually have a minimum one can borrow at one time. This is now $5000.
You should check out rates of these loans at tax time. Some banks offer lower rates then because they know borrowers will be attracted by the tax benefits.
Banks are the normal place to shop for home equity loans, but credit unions also offer them. If you belong to one, check it out. The rates are usually better than banks.
Home Equity Line. This is set up the same way as a home equity loan (variable interest, cap etc.—and it's tax deductible); but the big difference is that it is a line of credit, and you are charged interest only on what you write checks for. So, for example, if you have a $50,000 line of credit but you only write a check for $1000, you'd only pay interest on the $1000—the money you use.
Like home equity loans, lines also have fees, such as for credit check, title search, and “points.” A point is a euphemism for the percentage of money the bank takes that is equal to 1 percent of the face value of the loan. If the loan is for $40,000, and each point is $300 and three points are charged, you would pay $900. Points can vary greatly from bank to bank and should be added in when calculating the cost of the loan.
Refinance Mortgage. This means that a certain amount of money is borrowed to pay off the old mortgage, and then you can borrow up to 80 percent on the equity. Interest is also tax deductible. Interest rates are generally lower than for home equity loans, but closing costs are typically a lot higher and may offset any interest savings. Interest is tax deductible.
Home Improvement Loan. These loans are generally given for five to seven years and interest rates now range from 9 to 15 percent. Loans may be from $1000 to a maximum of $20,000. The disadvantage of these loans is the relatively short payback period, which results in high monthly payments. The loan when secured by a house is tax deductible and fees are small—just the $75 or so it costs to make a credit check.
HUD Home Improvement Loan. The FHA, under its Title I program, insures loans up to $25,000 on single-family dwellings. The loans are available at a variety of banks, and rates are about the same as for a secured home-improvement loan. The plus here is that the government insures the loan, and it will insure loans of people who don't have a lot of equity. (That's why it was created.)
Put It in Writing
Any changes to the original plan should be in writing, and while you may add something to it, you may also subtract something else. Don't forget to subtract these “deducts,” as they're called in the trade, from the original estimate.
Unlike a regular home-improvement loan, which usually has a payback period of five to seven years, you can take fifteen years to repay this loan. This type of loan is also available for multiple-family units. Loans may be $12,000 per unit up to $60,000.
401k Loan. Under this loan, you can borrow against profit-sharing monies. The interest rate is just a little above prime, and there are no fees.
Life Insurance. If you have life insurance, this is another source to consider. Rates are low and you can borrow up to 100 percent of the cash value of the policy.
Unsecured Personal Loan. This is a very expensive loan, three to five points higher than a home-improvement loan, which is secured by the house. There is no tax deductibility, and the payback period is three to five years.
Contractor Arranged Loan. This is where the contractor arranges the loan through a bank for you. We think it's a bad idea. In essence, it eliminates shopping around, and, in some cases, the bank will pay all the money to the contractor. If the contractor doesn't complete the work—or even start it—guess who's responsible to the bank for the money anyway?
Cash. You could dip into your savings to pay for the job, but this could deplete resources you have standing by in case of an emergency. Then, if you needed cash, you'd have to use other methods to get it.
To sum up, the best way to insure an adequate cash flow for the job and the best possible loan is to shop around, taking into account the total cost of the loan—which includes fees, the amount that can be saved in tax deductions, and, of course, interest rates. It is heartily suggested that you make a little chart and then get on the phone with sharpened pencil in hand. Seeing the figures side by side will be revelatory—and can save you, as suggested earlier, a lot of money.