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Financing Home Improvements | monrovia homes for sale - monrovia real estate
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Financing Home Improvements

By Josh Garskof

Few expenditures are as rewarding as a home renovation. Whether you transform a cramped kitchen into a cook’s paradise, create a basement apartment for an elderly parent, or address long-deferred home repairs, your family gets to enjoy the results daily. Plus, the improvement increases the resale value of the property, which means the project might eventually pay for itself or even help you turn a profit. (See related article on REMODELING PROJECTS.) First, though you will need to figure out a way to pay the contractor.

The best loan choices have one thing in common: You borrow your own money. The lender essentially gives you back some of your equity; you gradually return it with interest. Because the bank holds your house as collateral, the interest you pay is tax deductible, and rates are far below those for credit cards and unsecured personal loans. Lenders offer three ways to borrow for a home improvement: cash-out refinancing, home equity loans, and home equity lines of credit.

Cash-out refinancing replaces your existing mortgage with a larger one that includes your renovations costs. With mortgage rates hovering just above 7% for much of 2001, cash-out refinancing is a popular choice. That’s because reducing the interest rate of your mortgage can offset the larger size of the loan in your monthly payment. Say you owe $100,000 on a five-year-old mortgage with an 8% interest rate and you are paying $800 per month. If you refinance at 7% and take out a new $120,000 mortgage to pay for renovation, your monthly bill will remain the same.

But for many people, refinancing is actually the most cost option, says Keith Gumbinger, vice president of HSH Associates, a company that surveys mortgage rates (www.hsh.com). “Folks who got their homes a few years ago may have interest rates at or below what’s available today,” he says. “On the other hand, people who’ve had their loans for awhile are starting to make a dent in their principal. Re-extending the term of your loan puts you back at the beginning, when you pay interest almost exclusively.”

What’s more, refinancing can mean hefty closing costs – typically 3% of the mortgage amount. The bottom line, says Gumbinger, is that cash-out refinancing makes sense only if your existing mortgage is less than seven years old, you can drop the interest rate by a percentage point or more, and you expect to stay in the house long enough that the monthly savings will pay you back for your closing costs. (For example, $6,000 in closing costs and savings of $200 per month would mean a thirty-month payback.)

A better option for people who do not fit the above refinancing profile is a home equity loan that uses your equity as collateral. Interest rates as of mid-July were in the high 8’s, but the more expensive rate is countered by the shorter term, which means less interest over the life of the loan, and by the fact that you don’t disrupt your progress on paying down the mortgage. Closing costs are lower, too – commonly less than 1% of the (much smaller) loan total.

Still, you may find the best interest rate on a home equity line of credit, which is like a cross between a second mortgage and a credit card – you pay it back at your leisure, so long as you make the minimum monthly payment. There are no closing costs and no risk of borrowing too much or too soon, because you spend as you go, using a checkbook or a credit card provided by the lender. Plus, the rates for such lines of credit are low right now (at about 7% in July, although they have variable interest rates, which fluctuate annually.)

There’s one major credit line caveat, though. Unlike standard loans, which demand regular monthly payments toward interest and principal, lines of credit may simply charge interest. If you pay only that, the loan can continue indefinitely. So to make these loans a sound choice financially, you need to pay down the principal monthly. For example, if you borrow $18,000, set a loan term, perhaps three years, and then spread the principal over the monthly payments ($18,000 divided by thirty-six payments equals $500 above the monthly interest payment).

To assess a line of credit, find out how future rates will be computed. Most are based on the “prime rate,” a term for the banking industry’s going rate, plus a bit more. Not long ago, equity lines of credit went for prime plus two percentage points. Now the average is prime plus ¾ of a point. Ask your lender this important question before signing up for anything.

Discuss loan options with your financial adviser, because, among other issues, home equity loans and lines have a cap on tax deductibility. Once you have selected the type of loan that fits your circumstances, it’s time to comparison shop. Check the current rates on websites such as www.bankrate.com, then call every lender doing business in your area. Sometimes a small neighborhood lending bank has the best rates.

Ask for an estimate of your out-of-pocket expenses (the bank’s closing costs, as well as recording and appraisal fees). Then plug the details into a web mortgage calculator such as the one at www.smart-money.com or www.bloomberg.com, and you will be able to determine your monthly payments and interest costs over the life of the loan. You’ll also want to ask about – and avoid – prepayment penalties (fees for paying extra principal or refinancing).

Be careful with home equity and line of credit loans. You can use these loans to pay off credit card debt, buy a boat, or take a vacation and still write off the interest. But doing so means plundering your home equity, which might take many years to rebuild. So, limit equity borrowing to expenses – such as a new roof or college tuition – that better the family over the long term.


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