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Dr. Don Taylor, CFA, advice columnistFinancing a new home plus improvements

Dear Dr. Don,
I have recently sold my home for $175,000. Our current mortgage payment on that home is $869 on a 30-year fixed rate mortgage at 4.9 percent. We have a payoff amount of $117,000 and will pay a real estate agent fee of 3.9 percent. With all that said, we are looking for houses and would like to know how to keep the mortgage payment down while still moving up in home. We have seen a house for $241,500. It will need about $17,500 in updates and improvements. If we choose this house we plan to stay there (10-plus years), providing nothing catastrophic happens. How would you finance this home?

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There are so many options out there and some are risky and some aren't. We know this home will climb in value after the improvements are done so refinancing may be an option later. What do you think? Again we would like to keep the payment under $1,450 if we are going to stay there. We can go higher if it is for a short period of time. We want to eventually live on one income, but we know that cannot happen here just yet.
Thanks for your input and advice,
-- Dave Decision

Dear Dave,
You do have a lot of choices. The crux of the problem is that the proceeds from the sale of your home represent about 21 percent of the new home's purchase price, while the desired improvements are about 7 percent of the purchase price. You can put 20 percent down on a first mortgage, only to turn around and borrow against it for the improvements; take out a piggyback mortgage and pay cash for the improvements, or just take out a first mortgage and pay cash for the improvements.

With a piggyback mortgage you take out a first mortgage and a second mortgage at the same time. The advantage to this is that there's no private mortgage insurance, or PMI, requirement on the first mortgage. The downside is that the interest rate on the second mortgage will be higher than the first mortgage. A Bankrate feature, "Should you jump on a piggyback mortgage?" talks about the problems with a piggyback mortgage in today's interest rate environment.

Putting down the net proceeds from the sale of your home and then borrowing the $17,500 as a second mortgage isn't all that much different from the piggyback scenario. You may be able to get a better rate on the home equity mortgage -- especially if you get a home equity loan versus a home equity line of credit.

Financing with just a first mortgage will subject you to paying PMI in the early years of the mortgage, but you'll reduce the interest expense on the improvements and potentially eliminate the need to refinance later on. I've put some numbers together below. You can make your own table using Bankrate's mortgage payment calculator or this PMI calculator.

Financing options:
Sales price: $175,000  
Real estate commission: $(6,825)  
Mortgage payoff balance: $(117,000)  
Estimated net proceeds: $51,175  
Needed improvements: $(17,500)  
Available for down payment: $33,675  
New house: $241,500  
Down payment: $33,675  
First mortgage amount: $207,825 Loan to value: 86%
Est. monthly mortgage pmt. $1,314 (30-year fixed at 6.50%)
Estimated PMI payment: $90  
Total monthly payment: $1,404 First mortgage + PMI
Purchase price: $241,500  
Down payment: $51,175  
First mortgage: $190,325 Loan to value: 79%
Monthly mortgage payment: $1,203 (30-year fixed at 6.50%)
Home equity loan: $17,500  
Estimated monthly payment: $117 (Interest-only HELOC at 8%)
  $128 (Principal and interest home equity loan at 8%)
Total monthly payment: $1,320 First mortgage + HELOC
Total monthly payment: $1,331 First mortgage + home equity loan

This analysis ignores any tax benefit from your being able to use the mortgage interest deduction, but it should be close among the three alternatives, at least in the early years. Ignoring any appreciation argument for when PMI should drop off based solely on the loan balance, PMI should drop off in six to seven years.

The second mortgage approach frees up some money in your monthly budget that you could choose to use in making principal payments or additional principal payments on the loan. Taking on some interest-rate risk with the HELOC with its adjustable rate and high HELOC payments would mean less money available to pay down that loan. The HELOC is also interest-only in the early years of the loan but may at some point become an amortizing loan with much higher monthly payments. If you like the second mortgage approach, the home equity loan has a fixed rate of interest.

With your plans to be in the house 10-plus years, I'd lean toward the certainty of the larger first mortgage plus PMI -- including the certainty that PMI will fall off in time -- but it's close enough among the alternatives that I don't see you making a huge mistake by choosing one of the other approaches.

To ask a question of Dr. Don, go to the "Ask the Experts" page, and select one of these topics: "financing a home," "saving & investing" or "money."'s corrections policy -- Posted: Sept. 15, 2006
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