The Best Way to Pay for Remodeling

Kiplinger's Personal Finance Magazine, August, 1999 by Elizabeth Razzi

Rising home values are freeing up a fortune for homeowners.

Bidding wars for homes in many parts of the country are producing two side effects for home-owners: Remodeling your current house may be easier than finding a decent house to buy. And rising home values offer the means to pay for the work. But what's the best way to raise cash for the contractor?

Carmen and Richard DeMarr of Fairfax County, Va., are paying for the $93,000 remodeling of their southwestern-style house with a "construction/permanent" loan from a local mortgage bank. The four-month project added a new family room, home office and deck. The loan starts as an adjustable-rate loan--the current rate is about 7.25%--during the construction period, then is transformed into a permanent 30-year (or shorter-term) mortgage.

Such loans are appropriate if you are building a new home or a sizable addition like the DeMarrs, and they help you make sure that your payments don't get way ahead of the builder's progress. The money comes in stages, or "draws," the first of which pays off the old mortgage and any home-equity debt. Subsequent draws pay the builder as construction progresses.

SMARTWAYS TO USE EQUITY. For smaller jobs, borrowing against your home equity is the cheapest--and most convenient--way to go. One choice is a "cash-out" refinancing--taking out a new mortgage that's large enough to pay off your old one and cover the cost of remodeling. The beauty is that your whole remodeling bill is paid off over 30 years at a fairly low interest rate--currently about 7.5%. However, many lenders require that you still have 25% equity left after taking cash out in a refinancing.

Although the rate may be higher, convenience makes some form of home-equity credit the best bet for many homeowners--especially if you refinanced when rates were lower. You have two choices. A home-equity loan gives you a lump sum of money at a fixed interest rate of 8.5% to 10% (depending on your credit rating), with a typical payback period of 15 years. Or you may use a home-equity line of credit. Average rates are about one-half percentage point lower than those on lump-sum loans, and flexibility makes a credit line the best choice if you're thinking of remodeling in phases. You might set up a $50,000 line of credit, for example, but actually borrow only $15,000 for a new kitchen this year. Next year, you might use $10,000 for a bathroom.

You do bear the uncertainty of an adjustable rate. Home-equity lines of credit are usually priced one or two points above the prime rate, which was recently 7.75%. But borrowers with the best credit ratings can often get a loan at prime.

Regardless of your credit rating, to get the best rates you'll still need to have 20% equity left over after you count both the first mortgage and the home-equity debt. Borrowers with good credit records can get loans with a 1.00% to 125% loan-to-value ratio, which means your total debt equals the home's value or even overshoots it by 25%. But interest rates on such loans can be as much as 2.5 to three points higher than on a loan that borrows against only 80% of your home's value, notes G. Richard Bright, senior vice-president at Countrywide Home Loans.

ALTERNATIVES TO EQUITY. Even if you don't have much equity yet, you're a candidate for a loan that lets you borrow against the equity you will have in the home after remodeling.

The Federal Housing Administration's 203(k) program will help you pay for extensive remodeling. The loan amount is based on the anticipated value of the home after improvements are in place. Rates on a 30-year term are about 8%.

You are restricted by FHA loan-amount limits, which max out at $208,800 in high-cost metro areas. But some lenders have their own variations on the FHA's 203(k) loans--without the government's loan limits--so checking with local banks could yield a bigger budget.

YIELDS

TOP-YIELDING MONEY-MARKET MUTUAL FUNDS

                                 RECENT       MIN.
Taxable                       3D-DAY YIELD   INVEST.

1. Strong Investors(*)           4.93%       $1,000
2. Bunker Hill                   4.79         5,000
4. Scudder Prime Reserve(*)      4.75        10,000
3. Wilmington Trust(*)           4.74        10,000
5. Aon(*)                        4.70        10,000

NATL AVERAGE                     4.29%

                                                      TOLL-FREE
Taxable                       WEB ADDRESS (WWW.)        NUMBER

1. Strong Investors(*)        strongfunds.com       800-368-3863
2. Bunker Hill                  payden.com          800-572-9336
4. Scudder Prime Reserve(*)     scudder.com         800-854-8525
3. Wilmington Trust(*)               -              800-254-3948
5. Aon(*)                            -              800-266-3637

                                     TAX. EQ. YIELD
                         RECENT         28%/31%        MIN.
Tax-free              30-DAY YIELD      BRACKET       INVEST.

1. Strong                3.29%         4.6%/4.8%       $2,500
2. USAA                  3.14           4.4/4.6         3,000
3. Vanguard              3.12           4.3/4.5         3,000
3. Boston 1784           3.08           4.3/4.5         1,000
5. American Century      2.98           4.1/4.3         2,500

NATL AVERAGE             2.71%         3.8%/3.9%

                                              TOLL-FREE
Tax-free              WEB ADDRESS (WWW.)       NUMBER

1. Strong               strongfunds.com     800-368-3863
2. USAA                       -             800-531-8448
3. Vanguard              vanguard.com       800-635-6511
3. Boston 1784        boston1784funds.com   800-252-1784
5. American Century   americancentury.com   800-345-2021