Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Construction or home equity loan?

Dear Dr. Don,
My husband and I are planning to build an addition on our home. We estimate the cost to be $200,000. Which would you recommend, a home equity loan or a construction loan, and why?

Our house appraised for $365,000 last fall when we refinanced, and the mortgage is a six-month ARM at 4.375 percent with a loan balance of $280,000. The construction process is expected to take six months, and we'll be having the work done professionally.
Thank you,
Elizabeth Exteriors

Dear Elizabeth,
You don't have enough equity in your home to use a home equity loan to finance construction. Whether a home equity loan makes sense after construction is finished depends on the new appraised value of your home.

Ideally, you would combine the construction loan with your existing mortgage into a new first mortgage. You'd only look at a second mortgage (home equity loan) if the appraisal weren't high enough to justify the new, larger first mortgage.

The real key to successfully financing the addition is in how the addition increases the appraised value of your home. Paybackestimator provides both regional and national averages for different remodeling projects.

Let's just say for discussion purposes that you'll realize 80 cents on the dollar for your addition in a best-case scenario and 60 cents on the dollar in a worst-case scenario.

The higher the loan-to-value, the harder it will be to roll the construction loan into a new first mortgage. That's when you would want to consider a home equity loan vs. refinancing.

-- Posted: March 12, 2002