What’s the biggest obstacle to your renovation fantasy? Is it an engineering issue? Zoning regulations? Navigating permits and approvals? Arguments over whether to invest in a man-cave or a walk-in closet?
Unless you’re sitting on a pile of cash, you won’t even get to these obstacles until you know how much money you can borrow. Your borrowing power can decide the scope of the project – and, in fact, the feasibility of doing anything at all. To get a sense of the options, I chatted with James Talbot, president of Premier Lending; and Billy Persohn, senior mortgage loan originator with Premier.
Talbot lays out three basic options: a traditional mortgage refinancing; a construction loan; and a home equity loan or credit line.
Cash-out Refinancing: This allows you to take out a new mortgage for an amount greater than what you owe on your home and then take the difference in a cash payment. That cash payment is then available for your renovation project (which, when complete, should increase the home’s value and restore some of your equity in the home). A cash-out refinancing is most advantageous when the homeowner can get a lower rate than the current mortgage carries. However, the homeowner’s equity must be substantial. Persohn says on a regular cash-out refinance, conventional loans limit financing to 80 percent of current appraised value and, on an FHA loan, 85 percent. Therefore, the owner of a house worth $300,000 could refinance for no more than $240,000 with a conventional loan. If the renovation costs $35,000, the owner could cash that out only if his current principal was about $200,000 or less. Remember that closing costs on a home mortgage run into the thousands of dollars, though they may be rolled into the refinancing.
Construction Loans: You can borrow higher with a construction loan. A homeowner with strong credit can borrow up to 95 percent of the home’s value – and that’s not current appraised value, but the projected value of the home after the renovation is complete. This is effective for projects that add square footage to a home. The interest rate on a construction loan tends to be higher than on a cash-out refinance, but the difference is only about three-quarters of a point, Persohn says.
Of course, there’s a catch: A construction loan is far more complicated than a cash-out refinancing. Since Murphy’s Law is in full effect during a renovation project, lenders are keen to minimize risk, so the approval process is thorny. Each step of the construction process must be complete in order to draw down on the loan, and not all contractors are willing to deal with the hassle, so a construction loan should generally be considered Plan B.
“When the equity is there, a cash-out refinance is definitely my first recommendation,” Persohn says.
Home Equity Options: Home equity options tend to have cheaper closing costs and receive quicker approvals than a cash-out refinance or construction loan. With a home equity loan or line of credit, the lender determines the potential amount by taking the current appraised value of the house, multiplying it by a percentage of value and deducting the amount owed on the mortgage. They are typically handled directly by banks, and Persohn says some allow loans up to 90 or 95 percent of current value.
Take a homeowner with a $400,000 house, pursuing a loan against 85 percent of value ($340,000). If he owes $300,000 on his mortgage, he can receive a loan or credit line up to $40,000. (Assuming he has the financial capacity and good credit.)
Home equity loans are more straightforward than equity lines. The bank makes the full loan upfront. Rates tend to be fixed and go into repayment immediately. There’s a fixed monthly payment, akin to a monthly car payment. The term might be anywhere from five to 15 years.
With a home equity line of credit (often referred to as a HELOC), the lender sets a draw period, during which the borrower can spend at will up to the approved amount. The interest rates can run as low as mortgage rates, but they’re typically variable, which means they can rise with a publicly indexed rate. As the borrower pays the principal down, the available credit increases, making it a more flexible resource than a home equity loan. Think of it as a variable rate home equity credit card, but with tax-deductible interest and lower interest rates.
Persohn and Talbot say some local banks, more comfortable in their knowledge of the New Orleans market, tend to be more aggressive home equity lenders. Home equity loans and lines of credit might be a good option for a homeowner who can’t improve upon his home mortgage interest rate with a refinance.
TIP Go with a broker or lender you trust, and be sure to get the terms of the loan as clear as possible up front. Unscrupulous brokers and lenders may overpromise or obfuscate critical details – such as prepayment penalties and fees.