Renovating Your Home

Winter is the time when many people begin planning a home renovation project. Renovation can be a great way to make your home a more enjoyable place to live while adding to the value of what is probably your most valuable financial asset. This article, the first in a series, will look at some first steps in beginning a home renovation project. What factors should go into your decision to renovate? And if you decide to go ahead with a project, how should you go about setting a budget and paying for the work?

Should You Renovate?
The first factor to consider is your enjoyment of your home. Only you know how much a renovated kitchen will add to your enjoyment of your home, and how long you plan to stay in your home and enjoy the renovation. The second factor to consider is return on investment. A word of caution: the value of your home depends on many factors. The location of your home and its overall condition will have the greatest effect on its value, but renovation will play its part. Renovated kitchens and new bathrooms generate the most value, usually adding 90 percent or more of the renovation’s cost to the value of your home. A new deck, a renovated bathroom, or a new family room will typically add 75 percent to 85 percent of the renovation cost, while you should recoup about 70 percent of the cost of a renovated home office.

Paying for Your Project
If you decide to go ahead with your renovation project, you need to decide how much you can afford. Remember that your budget should include at least 20 percent more than your expected project costs to cover changes and additional expenses that you haven’t anticipated.

Depending on the size of your project, you may be able to pay for it out of your personal savings or by borrowing against personal assets such as a retirement fund, life insurance policy, or investment portfolio. But if the project is significant, it is more likely that you will need to seek some form of financing to pay for all or part of the project’s cost.

There are many different types of loans available—which one is right for you will depend on your circumstances. Some of the most common loans include:

Home equity loans. These loans let you borrow against the equity you have accumulated in your home, typically up to 75 percent or 80 percent of the equity value. You can easily calculate the amount of equity you have in your home by subtracting the outstanding balance on your mortgage from the home’s fair market value. Because a home equity loan is secured by your home, just as a mortgage is, you can write off the interest you pay on your income tax return. Interest rates on home equity loans are typically slightly higher than rates on a standard thirty-year mortgage. Closing costs can be high, however, and if you default on a home equity loan, you could lose your home.
Home equity line of credit. This is an open-ended, adjustable-rate line of credit with your home as collateral. You can use the line of credit as you need it, up to a limit of between 75 percent and 80 percent of the equity value in your home. Home equity lines of credit usually carry a variable interest rate based on the current prime rate or another index. The interest rate is generally about 1.5 percent higher than a first mortgage, but is not charged until you spend some of the money in the line of credit. Interest paid on the money you borrow is tax deductible. The danger with a line of credit is that it’s very easy to go over budget.
Second mortgages. A second mortgage is just like your first mortgage, but it’s next in line for repayment if you can’t pay your debts and the lender forecloses on your home. It’s a fixed-rate, fixed-term loan based on the equity in your house that is paid back in equal monthly installments. A typical second mortgage is a five- to twenty-year loan for 75 percent to 80 percent of the home’s equity value. Interest rates are slightly higher than for a standard thirty-year loan. Once again, you’ll face closing costs and you may even need to buy title insurance and pay processing fees. The interest is tax-deductible.
Cash-out refinancing. If interest rates today are lower by two percent or more than when you first bought your house, refinancing your mortgage can be a smart move. This allows you to use the equity in your home to take out a new loan to pay off your existing mortgage and then use the remaining funds for your renovation project. A typical refinance involves an adjustable or fixed-rate 15- to 40-year loan for 75 percent to 80 percent of the home’s appraised value. Depending on the balance of the original mortgage, the remaining cash from the refinancing can be used at the homeowner’s discretion. Some lenders will refinance up to 95 percent of the home’s appraised value, though interest rates will be higher. Closing costs may include appraisal and points. The interest is tax deductible.

Under no circumstances should you feel pressured to sign loan documents or feel confused about what you are being asked to sign. A reputable lender will be patient and straight with you. Take your time in deciding which method of financing is best for you. Be sure that you understand all of the terms of the loan. Remember, if you have second thoughts about signing for a loan, the federal Truth in Lending Act gives you three business days after signing to cancel a contract. If you have any questions or concerns, talk to an attorney before you sign.

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