How to pay for a home renovation

#Start with two numbers: the project cost and your usable equity

Every financing choice for a renovation comes down to what you can borrow against and what it does to the mortgage you already have. Before you call a lender, write down:

1. The project cost, from written bids, plus a cushion for surprises.
2. Your usable equity — the home’s value times the lender’s combined loan-to-value (CLTV) limit, minus what you owe.

Lenders set their own CLTV limits; 80% is used here as an example. On a $400,000 home with $220,000 owed, that leaves $100,000 — plenty for a $60,000 kitchen and bath remodel. On a $320,000 home with $262,000 owed, it leaves $0. The how much equity can you borrow guide walks through the math. Those two households need different answers, and so does a buyer who wants to fix up a home before moving in.

#One $60,000 project, four ways to pay

Take the first household: a $400,000 home, $220,000 left on a 4% mortgage with 25 years to go, and a $60,000 project. The HELOC rate is the prime rate (7%) plus an example 1-point margin; the home equity loan rate is an example one point above today’s 30-year average, rounded. Neither is a quote.

Three things stand out:

• The cash-out refinance is the most expensive by far in this case, because it moves $220,000 from 4% to 7.24% as well as funding the work. Its extra interest is about 6 times the home equity loan’s. The effective rate behind that is worked out in is refinancing worth it?
• The home equity loan has the lower total interest of the two second-lien options here, because it is repaid over 15 years instead of up to 30 years.** Its payment is fixed. The home equity loan guide covers terms and costs.
• The HELOC has the lowest starting payment but the most interest if you only pay interest during the draw period. Paying principal from the start closes most of that gap. How the line works is in the HELOC guide.

If your current mortgage rate is at or above today’s average, the picture changes: a cash-out refinance no longer reprices a cheap loan, and it can beat a second lien. Cash-out refinance vs HELOC runs that comparison.

#Match the loan to how the contractor gets paid

Renovations are paid in stages — a deposit, then payments as work is finished. A home equity loan hands you the whole amount at closing and charges interest on all of it from day one. A HELOC charges interest only on what you have drawn.

Say the contractor is paid in thirds: at the start, after three months and at completion after six months. Interest during those six months comes to about $2,475 on the home equity loan and $1,200 on the HELOC. The gap is modest; the bigger benefit is that a HELOC leaves unused credit for overruns without a second application.

#Renovation mortgages: lending on the after-repair value

Equity loans are limited by what the home is worth today. Two mainstream programs instead size the loan on what it will be worth after the work, and pay the contractor from an escrow account as the work is inspected:

Both work for a purchase or a refinance. FHA caps the base loan at 110% of the after-improved value and applies its usual loan-to-value limits; HomeStyle uses the as-completed appraisal, and if you can’t live in the home during the work it can finance up to 6 months of payments. The trade-off for both is process: detailed bids, an appraisal on plans, inspections before each draw, and contractors the lender accepts.

#When equity is thin: borrowing against the finished home

Now the second household. The home is worth $320,000, they owe $262,000 — 82% of its value — and an 80% CLTV cap leaves nothing for a HELOC or home equity loan. The same $60,000 project is expected to lift the value to $390,000.

The renovation budget is far below the cap, so the loan-to-value ratio is what the lender will focus on. Because the whole mortgage is replaced, this route makes most sense when the current rate is close to today’s average — otherwise the repricing cost shown in the first table applies here too.

#Buying a fixer-upper: 203(k) or HomeStyle

For a buyer, a renovation mortgage avoids a second loan right after closing. Say a home costs $300,000, needs $60,000 of work and should be worth $380,000 when done. The project fits under the $75,000 Limited 203(k) cap if the work is non-structural.

At the same rate, HomeStyle costs $66 a month less here. FHA needs less cash up front and is more forgiving on credit, while HomeStyle’s PMI can be cancelled later; actual FHA and conventional quotes often differ, so compare both Loan Estimates. The FHA loans guide covers the credit and MIP rules.

#Paying cash, or part cash

Savings carry no interest, no lien and no closing costs. If the project can wait, saving $1,000 a month covers $60,000 in 60 months. The 15-year home equity loan above costs $44,775 in interest — about 45 months of that saving. Paying part in cash and borrowing the rest shrinks every number in the first table.

If you do borrow against the home, interest on a home equity loan or HELOC is tax-deductible only when the money is used to buy, build or substantially improve the home that secures it — a renovation usually qualifies. The home equity interest guide has the limits.

#Which option fits which situation

1. 1

   Get written bids

   Two or three detailed bids give lenders and appraisers something to work from.

2. 2

   Check your equity and rate

   Usable equity at a lender’s CLTV limit, and your current rate against today’s average.

3. 3

   Price two routes

   Ask for Loan Estimates on a second lien and on a renovation mortgage or refinance.

4. 4

   Line up the draw schedule

   Renovation loans pay contractors after inspections; agree the timetable before work starts.

5. 5

   Keep a reserve

   Hold back cash or credit for the surprises renovations tend to find.