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

Best type of loan for remodeling

Dear Dr. Don,
My husband and I retired in 2000. We paid cash for our retirement home and then spent another $25,000 remodeling our home. Unfortunately, we need to put another $20,000 into the house to get it completed. We want to borrow the money to finish the house. We only have a fair credit history due to a previous failed business venture. What type of loan should we go for?
Thank you,
Linda Leisure

Dear Linda,
With a 100-percent equity position in your home, getting a $20,000 mortgage loan, even with only a fair credit history, shouldn't be a problem.

Beyond looking at your credit, lenders are looking at the money they have at risk when they extend you credit. You may not get a lender's best rate, but you won't get its worst rate either. See this Bankrate feature to estimate how a lender would grade your credit.

Then go to Bankrate's Shop & Save channel to order your Equifax credit report and FICO credit score to see exactly where you stand. It costs just $12.95.

You have three choices of loans: a home equity loan, a home equity line of credit (HELOC) or a first mortgage. Which loan is best depends on your retirement budget and your financial goals.

A HELOC is revolving credit like a credit card. That means you can get the loan, pay it down and then be able to borrow the money again if you need to up until the loan's final maturity. HELOCs are variable rate loans and have (at least initially) lower interest rates than the other two loan choices because the lender shifts the risk of rising interest rates to the borrower.

The home equity loan is set up like a fixed rate mortgage. The interest rate doesn't change, monthly payments are fixed, and principal is repaid (amortized) over the life of the loan. This type of loan is good for project oriented financing like your home improvements because you aren't tempted to re-borrow the money like you might with a HELOC.

A first mortgage can have several advantages. You can extend a first mortgage over a longer time period than a home equity loan. While you'll pay more in interest expense by extending the loan term, you'll also reduce the monthly payments. That can be important when living on a fixed income.

Home equity loans and HELOCs have advertised rates based on the assumption that a first mortgage on the property exists. Without a first mortgage, your home equity loan is in effect a first mortgage, but you may have problems determining whether the lender has priced the loan to reflect your situation.

Your choices in interest rates are also more varied with a first mortgage. You can choose an adjustable rate mortgage (ARM), a fixed rate mortgage or something in between. The loan term can vary from 10 years to 30 years, with 15-year and 30-year loans being the most common choices. It may, however, be difficult to find a first mortgage lender that is willing to loan you only $20,000 regardless of the loan term.

With no first mortgage outstanding, the closing costs between a first mortgage and a home equity loan could be fairly close. Home equity loans usually have lower closing costs because the lender can use information available from the first mortgage and that's not true in your situation.

If you've got a nest egg outside of the equity in your home, then a home equity loan makes sense. If you don't have a ready reserve to use in an emergency then I like the HELOC's revolving credit terms. As you pay down the $20,000 you can tap your home's equity for other reasons without having to get another loan.

A reverse mortgage could give you access to the money without being tied to a regular payment schedule. You borrow against the equity in your home, but the bill doesn't come due until you sell the house or your estate sells the home. Both of you need to be at least 62 to consider this alternative.

I don't think this is your best choice, I'd rather see you hold that option in reserve, but you can learn more about reverse mortgages in this Bankrate feature.

-- Posted: April 26, 2002