1-11-19: What are our mortgage options for remodeling our home?
Question of the week: What are our mortgage options for remodeling our home?
Answer: There are several options for paying for major home improvements or remodeling. Most commonly used for paying for major home projects are cash, a home equity line of credit or fixed rate second trust deed, new primary loan with cash out, new renovation loan, or possibly tap other resources. Here are some basic guidelines for the various financing options.
Cash: Depending on the scope of your project you may have enough money saved to pay for your construction project. The obvious advantage is lack of any interest costs and monthly payments. Keep in mind that many remodel/renovation projects can end up costing more in time and money so make sure you have enough to cover cost over-runs as well as whatever post-project expenses you may have—such as new furniture, floor coverings, etc. If you are using cash for your remodel you may want to obtain a home equity line of credit for a small amount to cover over runs to ensure you do not run out of funds during the project and then may be unable to obtain financing because part of your house is torn apart and not yet put back together. If you do not need to access the available funds that is great, but if you do you will be prepared and seamlessly be able to continue and finish your project.
Home Equity Line of Credit (HELOC): A HELOC is like a credit card, you are approved for a maximum amount of credit and then you can access as much of the funds as you need up to the credit limit, you make payments based on the amount of the outstanding balance. A big advantage of HELOCs and remodeling is you only pay for the amount of money you need when you need it. For instance, your project is estimated to be $50,000 with 20% paid upfront to get started and then other funds paid to the contractor at certain points of completion with the final amount due when all is complete. You sign the contract and access $10,000 and pay the contractor, you bill comes the next month and you owe the payment due based on $10,000. The next month you pay another $15,000 to the contractor and not having paid any principal on the first payment, you made an interest only payment, your next bill will be based on the $25,000 balance. This gives you flexibility based on how you use the funds available.
Another advantage of HELOCs is many lenders will provide lines of credit at a higher loan-to-value (LTV) than you may be able to obtain with a fixed rate loan or traditional mortgage. This enables you access to more funds than you would otherwise be able to obtain.
The disadvantages to HELOCs are the rates are variable, tied to the prime rate so over time it is hard to budget total costs; for example, since December 2016 the rate has increased 2%, while during this period the 30 year fixed conventional rate is only up 0.25% (after being higher by 0.75% a few months ago). The other disadvantage is self-imposed by the borrower—interest only. The minimum payment due on most HELOCs is an interest only payment, many borrowers fall into the habit of paying interest only which results in a large balance remaining on the loan which has to be paid at some point in the future either through a refinance or sale of the home.
Fixed rate Second Trust Deed: This financing instrument operates like a traditional fixed rate mortgage, however because it is in second position the rate is higher than available primary mortgages at the time of the transaction. The advantages of the fixed rate second are the ability to budget exactly what the payment will be for the period of the loan (generally available in fifteen or twenty year options) and if your current mortgage has a rate that is significantly lower than your current rate you can retain that rate and payment.
The disadvantages of the fixed rate second are many lenders restrict the LTV to 80% (same as most primary mortgages) and the higher interest rate.
Cash-out Refinance: This option is pretty straightforward, you refinance your existing mortgage and increase the amount borrowed to cover the funds you need up to the LTV allowed by the loan program. Most cash-out programs limit the loan balance to 80% of the appraised value of the home so if you are going with this option it is a good idea to have a good estimate of the value of the property.
The advantages of the cash-out refinance option are that you have a 30 year fixed rate mortgage. This provides you the lowest possible payment due to the long amortization, a fixed rate throughout the term of the mortgage which enables you to budget your monthly housing payment with certainty. Another benefit for many homeowners is depending on how long you have had your current mortgage and the increase in monthly payment may not be as high as you would expect; for instance we are closing a loan with a borrower accessing $75,000 and their payment is going up only about $275 per month, whereas their option on a fixed second increased their payment by almost $700.
Disadvantages of the fixed rate option are you are provided all the funds at closing and begin making payments on funds that may be sitting in the bank waiting for your project to begin and through the finish. Another is your interest rate may increase from your current mortgage rate.
It needs to be noted that when pricing mortgages a cash-out refinance are costlier than a rate and term refinance and a purchase transaction. The higher the LTV the more expensive the loan, conversely if you have a lot of equity in the property your costs would be lower if you LTV falls below certain price points based on the appraised value and how much your are borrowing.
Renovation Loan: This option is a combination of a traditional fixed rate mortgage and a HELOC and can be used to purchase a home you wish to remodel or as a refinance of your existing home for major renovations. We will use as an example a refinance.
Your current home is worth $550,000 and you owe $325,000. You wish to add a bedroom, a full bathroom and remodel the kitchen. The total costs are $125,000 and after the work is completed the value of the property will be $645,000. We complete the loan application for a mortgage of $450,000, $325,000 to pay-off your existing mortgage and $125,000 for costs to remodel. With our loan package besides the standard information we would need to show you qualify we will also need plans and estimates of costs from your contractor. During the loan processing we will make sure your contractor is approved by the lender and have an appraisal completed that includes the current value and the value of the home after the project is complete.
All goes well and the loan is approved and we fund the mortgage, your existing mortgage is paid off and the excess funds are placed in an escrow account controlled by the lender. After certain parts of the project are completed you request a draw from the account, the completion of that part of the project is verified and funds are transferred and you can pay the contractor. At the end of the project you have used all the money on the mortgage and your contractor is paid.
Advantages of this option are that you have a 30-year fixed rate mortgage upon completion of the project and the rate is competitive with a traditional mortgage or cash-out transaction. Another advantage is your contractor is vetted by the lender—which in our experience has resulted in some borrowers needing to change contractors after issues arose regarding insurance, licensing or past issues with the contractor that the lender discovered the borrowers were unaware of when they selected the contractor. This may sound like a negative, however should something occur with the contractor during the project it is a nightmare; knowing a contractor had issues in the past decreases the opportunity for such nightmares to occur.
A disadvantage for many borrowers is the process to get to loan approval, which is longer and significantly more thorough than the traditional approval process—it is a bit more time and effort but understandable due to the nature of the project. Another disadvantage for some is the draw process where the contractor is not paid until certain completion points in the construction. Many contractors want funds before they start the process, using the renovation process they may not get the funds until after the process; some borrowers mitigate this issue by fronting the funds to the contractor and then getting reimbursed through the draw process.
Piggy-back: Some homeowners do their own version of the renovation loan by maximizing their funds available with a traditional 30 year fixed rate mortgage and then add a HELOC onto the property for additional funds. For instance you need $80,000 for your project and a cash-out refinance will enable you to obtain $65,000, you obtain the additional $15,000 needed on a HELOC—what we call a piggy-back transaction as your HELOC piggy-backs on your first mortgage. The advantage of the fixed rate 30 year loan for the bulk of the funds needed combined with the higher LTV of the HELOC lets you complete your project with the best of both options.
Reverse mortgage: Yes, reverse mortgages can be used for home improvements if the borrower qualifies and enough equity is in the property.
Other options can include borrowing from the bank of mom and dad, possibly borrowing against your 401(k) or a margin account on an investment account.
One of my favorite books we used to read to the kids was If You Give A Pig A Pancake. I usually encourage any family looking to do an extensive remodel to read the book as it is a good metaphor for many such projects. A major pitfall for most homeowners is underestimating the amount of work and costs that will need to be done to accomplish their goal of another bedroom and bath and a remodeled kitchen. Once walls are open what will the contractor find? Out of date and code electrical? Inadequate framing? Foundation issues? A rotted out floor under the shower? The original choices for cabinets or fixtures are not available adding time, and/or costs, to the process? You forgot that with the newly remodeled home that you now need furnishing?
A high percentage of the time when I have clients undergoing a remodel they let me know that even though they thought they were being somewhat liberal in the costs they still were short of what was needed. Read the book and imaging instead of a pig going through your home in search of a pancake it is your remodeling project needing more and more done to ensure completion.
Be very thorough in your plans, go deep into your interviews with contractors as to typical issues that come up, and possible issues given the age of your home, location (for instance we are on expansive clay soil which causes foundation issues—not all contractors are aware of this) and scope of your project.
All that said, I usually counsel clients that are considering extensive home improvements that before they commit to explore the options of what homes are on the market that would achieve the same objective. If you are looking to add a bedroom, bathroom, modernize your kitchen or other work that entails a lot of time and money, evaluate the current value of your home, what your net proceeds would be if you were to sell, what loan amount and sales price you will be able to qualify for and feel comfortable paying and then look at the local market to see if it makes sense for you to purchase what you want.
You may find that you prefer to remain in your current home and endure the remodel process, or you may find that you would benefit by purchasing a home that meets your needs.
Whichever route you choose to take please contact me to go through all your options and the advantages and disadvantages of each.
Have a question? Ask me!
Words matter, especially when they are the words of the Federal Reserve Open Market Committee (FOMC)—the group that sets the Federal Reserve borrowing rates which impact other rates such as the prime rate. The minutes from the last FOMC meeting were released this week and they showed that while all the voting members say “yes” to increasing rates at the last meeting there was some discussion by some to not raise rates. As well the minutes showed that future rate increases are not guaranteed. This is positive news for mortgage rates.
More positive rate news today as the Consumer Price Index dropped in December for the first time in nine months, primarily due to lower gasoline prices. Also declining was the year over year cost of living, dropping to 1.9% growth from the annualized growth of 2.2% in November. The 1.9% price increase was the first time since August 2017 the important data point was below 2%. The news is very mortgage rate friendly as the Fed uses the data for their gauge of inflation and the desired price increase for the Fed is 2% per year. If the price decrease remains below 2% moving forward it puts pressure on the Fed to not increase rates.
Rates for Friday January 11, 2019: For the first time in six weeks rates have not declined, and prior to today’s CPI data we might have seen them bump up a little bit. Upward pressure on rates this week was caused by gains in stock markets as investors felt confident about the on-going trade talks with China. At this point the government shutdown is not have much, if any, impact on financial markets.
FIXED RATE MORTGAGES AT COST OF 1.25 POINTS LOCKED FOR 45 DAYS:
30 year conforming 4.125% Flat
30 year high-balance conforming 4.25% Flat
Please note that these are base rates and adjustments may be added for condominiums, refinances, credit scores, loan to value, no impound account and period rate is locked. Rates are based on 20% down with 740 FICO score for purchase mortgages.
Since the end of the last football season my ring tone has been the Philadelphia Eagles fight song, “Fly Eagles Fly.” Starting in March of last year our youngest has asked me, “how long are you going to have that as your ring tone?”
“As long as they are the reigning champions.”
On Sunday I thought I would have to change my ringtone, thankfully the left-hand of the Eagles defensive tackle deflected the Bears’ kicker’s field goal attempt just enough to cause it to hit the upright and the cross bar so I retain the ringtone at least for one more week.
Not overly positive with this week’s game against Drew Brees and the Saints, but hopeful that next week at this time when you call I will still hear, “Fly Eagles fly, on the road to victory….”
Have a great week,
Dennis
Past Weekly Rate & Market Updates can be found on my blog page at my website www.DennisCSmith.com/my-blog
