When financing a home improvement or construction project, homeowners should carefully evaluate all of the various options. Home equity loans and home equity lines of credit (HELOCs) are two of the most common financing choices; for financing the building of a new home, a construction loan is generally the preferred method of financing.
The size of these loans will largely depend on the amount of untapped equity available, or the projected costs of the project. Many sophisticated homeowners use these loans to repair, remodel or build their homes, thereby increasing the value of their properties.
Let's take a look at the difference between the various types of loans for home improvement or construction:
Home Equity Loans
Most people choose a traditional fixed-rate home equity loan when planning a one-time project, such as a home addition or a renovation project since the borrowed money is paid out as a lump sum and the amortization schedule is locked in with a constant monthly payment, including both interest and principal for the term of the loan.
There are certain considerations to bear in mind if considering a home equity loan. First, when the loan is paid off, you cannot reuse it for another project and must apply for a new loan.
Second, interest rates on these types of loans are usually higher because they are guaranteed fixed-rate loans. And finally, for homeowners who already have mortgages with an outstanding balance close to the home’s value, they may not have capacity for more debt, given the fact that lenders are unlikely to extend more than 75% to 80% of the total value of the house.
Home equity lines of credit offer greater flexibility than home equity loans. Since the HELOC is a revolving credit account, interest only accrues when funds are borrowed, not when the loan is opened. When evaluating a HELOC, the most complicated decision may be deciding between a fixed interest rate and a variable interest rate.
The interest rate for a variable HELOC fluctuates more frequently than a home equity loan, depending upon the terms. The interest rate for a HELOC is often tied to a particular underlying rate, such as prime or prime plus 0.25% percent, 0.50% or more.
In these cases, when the base rate changes, so will the HELOC interest rate as well as your required monthly payment. With increasing rates, not only will your borrowing costs rise, but the larger payment will leave you less cash flow for retirement saving or other expenses.
To protect against such circumstances, consider a home equity loan or fixed-rate option HELOC. In exchange for the fixed interest rate, you will generally pay a higher interest rate than offered on the variable-rate option.
A popular form of equity line is an interest-only HELOC. This is usually a variable-rate interest line of credit on which you pay just the interest over a term of 10 or 15 years. At the end of the term, you have what is called a "balloon" payment for the unpaid principal that you must pay off in cash.
The balloon payment may also be prepackaged in what is known as a "two-step mortgage." Here, the large one-time balloon payment is rolled into a continuing amortized or new mortgage at current market interest rates.
With a HELOC, you also can pay off and reuse this credit for as long as you keep the line open.
Balloon payment risk is exacerbated during a declining housing market, such as the one we experienced in 2008-09. If you don’t budget for the expected balloon payment, or your financial situation is adversely impacted, you may not be able to afford the balloon payment when the time comes to pay off the loan.
One way to avoid the burden of that final balloon payment is to make ongoing payments of both principal and interest during the term of the HELOC, even if you are required to make interest payments only. It is important, however, to make sure that your lender does not penalize you for any prepayments of principal.
For very large home projects, your builders or contractors may require a sizable upfront investment, followed by later payments as the project progresses. Generally speaking, a HELOC will not be appropriate for this kind of funding. For those seeking to build a new house, a construction loan is a possible option. However, these loans can be difficult to obtain without a sound banking record, given that the lender’s collateral—i.e. the home—is not complete.
If approved, the lender will coordinate the disbursement schedule with the construction timeline, after verifying the progress and quality of the construction. The borrower will only be making interest payments during this period. Once the project is completed, the construction loan usually can be rolled over into a mortgage loan.
Applying for a Loan
Before applying for any type of home loan, it is strongly advised that you determine the projected cost of the renovation, along with an estimated date of completion. This may involve contacting several contractors for price quotes and project timeline.
The loan process shouldn’t begin until a concrete plan is in place. Furthermore, you should discuss the tax implications with a qualified tax professional. Depending on certain factors, the interest on the loan may be tax deductible.
Any loan involving property comes with implicit risks. Failure to maintain monthly loan payments may result in the loss of your home.
A CFP® professional can help you evaluate different loan options. You should consider your goals, future earnings, monthly expenditures and ability to assume risk. With thorough research and preparation, a house equity loan, a line of credit or a construction loan can be a valuable tool for any homeowner.