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

Financing a home addition

Dr. Don,
We are seriously considering adding an addition onto our house, but we are unsure of the best way to go about financing the work. The home's current value is $230,000 with a balance of $133,000 remaining on the 7.25 percent, 30-year fixed-rate mortgage. The estimated cost of the addition is $65,000. We currently have excellent credit and no other debt.
Peter Plumb

Dear Peter,
You have three choices: a home equity line of credit (HELOC), a home equity loan, or a cash out refinancing of your existing mortgage. Which choice is right for you depends on your budget, the interest rates available and your tax situation.

Your budget is an important consideration because a home equity loan amortizes over 10 to 15 years, giving you higher monthly payments than if you refinanced with a 30-year fixed rate loan. If you can afford the higher payments, you'll wind up paying less in interest by paying off the loan over the shorter time span.

But remember that you can always make additional principal payments on the 30-year mortgage and accomplish the same result, usually with lower interest expenses.

Another budgetary consideration is that closing costs are much lower for home equity loans than for first mortgages. If, as most people who are contemplating additions are, you plan on being in the house for a while, the lower interest expense on the mortgage will outweigh the higher closing costs.

Let's assume that you can use the mortgage interest expense deduction on your taxes. So the relevant cost of debt is your after-tax cost of debt. This IRS flowchart will help you determine if the interest expense will be tax deductible.

Since you want to borrow more than 80 percent of the home's value, a new first mortgage will require private mortgage insurance (PMI). PMI will cost about $172/mo. during the time that the policy is in effect. In the table below I show some different financing scenarios but assume that the PMI policy will be in effect for only seven years. You could use an 80-10-10 mortgage to avoid PMI, but it's not likely to be cost effective.

I like the idea of using a home equity loan. Once the addition is complete, you can have your house reappraised. You should pick up enough of an increase in the appraised value of the home that you could then do a refinancing and not be required to have a PMI policy on the loan. If you choose this course, make sure that there aren't any prepayment penalties on the home equity loan, and try to keep its closing costs to a minimum.

Michael Larson's survey of closing costs, and Holden Lewis' feature, Understanding cash-out refinancing, will provide you with additional background about tapping your home's equity to finance your new addition.

-- Posted: Sept. 18, 2001