for your remodeling plan
1. Take out a home equity loan
Also known as a second mortgage, home equity
loans are made against the value of your home.
The bank uses the equity in your home as collateral
and puts a lien on your home. Interest rates,
normally fixed, are often higher than on a
first mortgage. Fees and closing costs are
relatively high, too, although they are lower
than with a refinanced mortgage. Fees and
closing costs, too, are relatively high compared
with other options.
One drawback is an 80 percent
loan-to-value ratio. If your house is worth
$250,000 and you owe $190,000 on your first
mortgage, you could borrow just $10,000 before
hitting that cap. If you want to make $40,000
in upgrades, you would have to go with either
a higher-interest loan or look for another
option. The interest you pay on the first
$100,000 of your home equity loan may be tax-deductible.
(To be tax-deductible, the IRS says you need
to use the money exclusively to pay for home
improvements, and you must itemize.)
Home equity loans work best for amounts you consider
medium to large and that require more than
10 years to pay back. They also typically
don't carry a prepayment penalty, so if you
get a bonus or other windfall, you usually
can pay it back early.
2. Consider a home equity line of credit
A home equity line of credit, or HELOC, is
a cross between a home equity loan and a credit
card. In fact, many banks give you a credit
card which you then use to access the money
in your equity line. Like a home equity loan,
the interest on the first $100,000 you borrow
may be tax-deductible.
The bank sets a "draw"
period during which you can take money from
the line, usually between five and 10 years,
and another span during which you must repay,
typically 10 to 15 years. HELOCs allow you
to repay your loan and then borrow again as
you need it during the draw period. The bank
only charges closing costs once, upon opening
the line. During your draw period you pay
back only accrued interest. After the draw
period ends, you must repay both principal
and interest. The primary drawback of a HELOC
is that the borrower is at the mercy of interest
rate movements. When rates go up, so do the
monthly payments. The option to pay interest
only, though, may tempt some borrowers to
take risks, says Ferrara.
A HELOC makes sense for short- to midterm loans and
especially when you need to withdraw money
over a span of many months. They also make
sense if you believe interest rates will fall
over the next year or two.