Financing A Remodel
Kevin J. Daum

This article was originally published in a 2007 edition of Log Homes Illustrated magazine.

After years in your home it’s time for a major facelift, or maybe you have outgrown the space and aren’t anxious to leave your neighborhood and uproot the family.  Whatever the reason, remodeling whether for minor cosmetics or major additions is more popular then ever.  Of course like all major undertakings the first thing to do is figure out how you will pay for it.  Here are the major financial considerations when planning your remodel.

Protect Your Value

Not all houses can financially support a major remodeling project.  While minor cosmetic repairs such as a new roof, flooring or paint job will keep your value from declining, it can be difficult to recoup the cost of opening walls or adding built-ins until some time has passed and appreciation has occurred.

Some remodeling choices have greater immediate value than others.  The kitchen, bathrooms and the master bedroom all enhance the value of the home when remodeled.  Of course these can also be the most expensive of upgrades and if you over do it or make it too unique you could have difficulty seeing those dollars come back to you at sale time.

Adding square footage can benefit a house greatly particularly if the home is small for its lot and smaller than other homes in the neighborhood.  Many older neighborhoods are transitioning to support larger homes these days and you may get more value by tearing down your home and building a new one from scratch.

Be sure not to expand too far past the size of the typical houses in the neighborhood.  Overbuilding for your neighborhood not only makes it harder to recoup build costs but could negatively impact your ability to sell the home in a moderate or slow market.  Buyers in general look to neighborhoods that have similar houses and appeal and while they may pay a little more for a slightly larger home, they are more likely to search for a neighborhood with bigger homes in general rather than pay a large premium for a giant home in your neighborhood.

Pay careful attention to aesthetics and usability when planning your remodel.  Not everyone is an expert on good design but most are critics when the design is poor.  It’s important to preserve the architectural integrity of the house so that it maintains curb appeal to future buyers.  Be aware that adding odd shaped rooms or causing strange traffic patterns that might be OK for you will drastically reduce the home’s marketability when it’s time to sell.

Try to finish the project all at one time.  Often partially finished projects suffer devaluation problems in spite of the owner’s good intentions to “finish that molding someday.”

Using Home Equity

Remodels can be costly and not everyone has sufficient savings to pay for work that can cost tens or even hundreds of thousands of dollars.   If your house currently has equity in it that exceeds the cost of your remodel you may be able to tap this equity to cover your remodeling costs.  One popular way of tapping this dough is through a Home Equity Line Of Credit or HELOC.

HELOCs can be beneficial if your 1st mortgage is at a low interest rate and you’re not sure how much of the money you are going to use.  HELOCS are large credit lines that allow you to draw money and pay it back as you wish.  You only pay interest on the amount you draw off the line so you can keep your payments down if you don’t need all the money.

These days most lenders will loan you up to 90 percent of the current value without needing you to provide a tax return.  This percentage will need to include both your 1st mortgage and the HELOC.  Some lenders may loan you more, particularly if your tax returns show sufficient income to qualify.  Rates for HELOCS usually float monthly and can range from a little below to as much as 3 percent above prime which is at 8.25 percent at the time of writing this column.

If the amount you need is more than your 1st mortgage or if the rate on your 1st mortgage is not super low then you might want to consider a full refinance to access your equity.  Often the HELOC payment plus the payment on your 1st mortgage can cost more than the single payment on a new mortgage.

A good, knowledgeable loan officer can help you calculate the “blended rate” of combining a 1st mortgage with a HELOC to determine if a new 1st mortgage for the entire amount would save you money.  Of course you want to factor in points and costs as well as the length of the loan term on the larger loan amount when trying for the maximum savings.

Counting on Future Value

When the cost of your remodel is greater than your available equity, it’s time to explore the option of a construction loan.  Construction Loans take into account what your property will be worth when it’s finished.  This allows you to borrow more money then the house is worth today so that you can pay for the whole project.

Most construction loans will require you to account for all of the money necessary to pay off the existing mortgage, cover the soft costs like permits plans and fees, include all the construction costs and cover the financing costs including loan fees and the interest carry during construction as well.  If the loan isn’t big enough, you may have to bring money from savings in order to close the deal.

A construction loan is similar to a HELOC since you draw funds as you need them but these loans follow a specific schedule and the bank will require an inspection of completion before releasing the funds for a completed section of the remodel.  The best construction loans today are All-in-One loans that automatically convert to permanent financing without re-qualification, re-appraisal or additional fees.

If a construction loan is your best route, find a loan officer who is experienced with these loans.  Many brokers and banks will offer to provide these loans as part of their lending portfolio but few of their loan officers are trained to understand how the product works.  Only a loan officer who has closed dozens of construction loans will be able to help you through the process in a smooth manner with no mishaps or surprises. 

Remember that rates and fees may less important with construction financing than finding the right terms such as length of build time or minimizing cash into the project.  Hoard your cash leading up to the project.  Construction lenders like to see lots of money in the bank.  Since construction projects are notorious for going over budget, always borrow the maximum amount at the beginning.   If you don’t use it all you can always roll to a smaller permanent loan at the end when you find out the true cost.

The Taxman Cometh

There are many tax implications associated with remodeling and financing.  Be sure to spend some time with your accountant to discuss how making various decisions can impact your taxes.  Here are a few considerations.

When planning for all the financial aspects of a remodel, don’t forget about property taxes.  Any time you make significant capital improvements to your property you could trigger reassessment by the local tax assessor.  Some areas such as California with its Prop 13 laws only reassess the property if you add square footage.  However, many other areas will assess on a regular basis and if there is a noticeable change or permits have been pulled the assessor may increase your basis causing your taxes to go up.  If they assess you too high you may be able to petition for a lower assessment especially if you can provide documentation that you paid much less for the improvements so keep those receipts.

On the plus side you may pick up some additional deductibility from your remodeling project.  Ordinarily you are limited to deducting mortgage interest on the lowest loan amount you have had to date plus up to $100,000 cash you may have taken.  However you can add the cost of capital improvements to this total.  So if your loan amount was $300,000 at 5 percent and you had a $100,000 HELOC at 8 percent, you would have been limited to writing off $23,000 annually.  Now if you get a new loan for $600,000 at 6 percent, you can write off $36,000 each year saving you an additional $3,900 at a 30 percent tax bracket.  Points are also deductible so buying down that refinance may be worth while.

With the low rates and great array of new loan programs this is a great time to finance that remodel.  Additionally the slight slowdown in construction has created a little softening in the price and availability of labor and materials so bargain hunters should be pleased.

The internet is a great resource for materials and contractors and its open 24 hours which makes it much easier to fit project planning into a busy schedule.  Make sure you spend as much time as possible planning out every aspect of your project before you start ripping down walls.  Once you demolish anything structural in the home getting any loan other that a new construction loan will be virtually impossible before it’s finished.  The worst thing is running out of money midstream so you want to have all you financing ducks in a row. 

A little extra advance planning will protect you against cost overruns as well as running out of cash.  Besides, you’ve waited this long to make the house the way you always wanted it, what’s a few more well spent months of planning.

About the Author...
Kevin Daum is the Founder and CEO of Stratford Financial Services, a Real Estate finance and education company, founded in 1989. Stratford specializes in Purchase loans, Refinance loans and Custom Home Construction finance and has successfully financed thousands of clients. He is the author of "Building Your Own Home for Dummies" (Wiley), as well as "What the Banks Won’t Tell You." Mr. Daum was an Underwriter for Plaza Savings and Loan and Key Bank of New York. He is an INC 500 CEO and has been listed as one the 40 Most Influential People Under 40 in the San Francisco Bay Area. He is the Global Chair for the Edison Innovation Program with the Young Entrepreneurs' Organization (YEO) and is a founding Board member of the Bay Area Chapter of YEO.

Mr. Daum is a frequent contributor to numerous business publications on the subjects of Real Estate and Small Business leadership and speaks regularly on both subjects. He can be contacted at kevin@stratfordfinancial.com.