home equity

What's best for financing home improvement?

Don TaylorDear Dr. Don,
We need to make some updates and improvements to our home as well as undertake a few cosmetic enhancements that will add to its appeal and market value based on our location and comparable homes in our immediate area. We expect the cost for these enhancements to be approximately $60,000 and are wondering about financing.

We currently have a fixed-rate mortgage and a line of credit. The balance on the 4.95 percent fixed-rate mortgage is $21,000, and the monthly payment, including taxes, is $1,206. The line of credit is $200,000, has a rate of the prime minus 1.6 points (currently 1.65 percent), and the outstanding balance is $172,000. The draw period on the line expires in October 2017, at which time we must pay off the balance in 10 years.

The estimated market value for a home like ours is $575,000. We are financially stable. Our gross income is $6,600 per month. We both have credit scores of about 769. We have three children: one in the third year of college, one entering college next year and one possibly entering college in a few years.

Our question is: Considering the current favorable interest rates on mortgages and refinance products as well as equity lines and loans, what would be the most cost-effective way for us to finance the $60,000 for our home improvement work? It seems every bank we ask has its own agenda to serve, and it's getting very complicated. We also find many bank loan officers are overwhelmed with requests and are impatient. We would appreciate your unbiased and straightforward feedback.

Thank you,
-- Jeanne & Tom

Dear Jeanne & Tom,
Even though you've done an excellent job in describing your situation, a solution isn't clear-cut. Your goal should be to minimize your total interest expense over a time period that allows you to pay off the loans while meeting your other financial goals. How you can do that depends in part on your lenders' willingness to work with you and your attitude toward interest rate risk.

I'm going to discuss the pros and cons of three options, along with some variations on these options:

  1. Ask the lender to increase your home equity line of credit to $235,000.
  2. Do a cash-out first mortgage refinancing.
  3. Pay off the first mortgage with the available balance on your home equity line and then finance the home improvements with a new home equity loan.

If you are able to increase the credit line to $235,000, you will have enough to take on the projects, you'll hold on to the low interest rate on the debt, and you shouldn't have to pay much, if any, in closing costs on the change to the loan. But the lender has to be willing to work with you. And note that you'll be hanging onto the risk that the line's interest rate could head higher in the future because it's based on the prime rate. You can manage that risk by aggressively paying down the loan balance.

A cash-out refinancing will pay off your existing first mortgage plus release money for your home improvements and repairs. The home equity line lender may have to agree to the refinancing. If it has to agree and won't, then you can look into refinancing both the first mortgage and the line of credit. The bad news is you will lose the low rate on your home equity line. You'll also pay the higher closing costs associated with a first mortgage. The good news is you will no longer face the interest rate risk on the line of credit, and you'll be locking in at near-historic low rates on mortgage loans.

Finally, you could look at taking out a home equity loan as a third mortgage. It's called a third mortgage because it's third in line to be paid in the case of foreclosure. It won't be a third for long because you'll pay off the first mortgage with the loan proceeds and have money to pay for your household projects. The closing costs should be minimal, but the interest rate will be higher than they are on your existing first mortgage. You'd take this approach if you wanted to hold on to the home equity line and if that lender won't sign off on the cash-out first mortgage refinancing.

It's difficult to come up with definitive solutions when you incorporate an adjustable-rate loan into the equation. You know your needs and comfort levels more than I could ever hope to. Which approaches are the lenders willing to discuss, and how willing are you to take on the risk of higher interest rates in the future to hold on to relatively low adjustable-rate debt over the next few years? Talk over these options with your lenders, and the best home improvement financing approach will rise to the surface like cream.

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