Getting a Mortgage for Home Improvements

If you are sitting in your home pondering a major expansion in the kitchen, finishing the basement, or completing key repairs of the home, a new mortgage is one potential source of funding for such a project.  Of course, there are many sources of funding for these undertakings.  Cash on hand, credit cards, or even personal loans can be used to help pay for work on your property. 

The key advantage of mortgage funds is that the rate you pay on a mortgage is almost always the lowest rate for consumer borrowing.  In addition, the interest paid on mortgage debt is generally tax deductible (seek the advice of your financial planner or tax advisor).  Furthermore, if a borrower is to take a mortgage to extract equity or cash out of the property, one of the best uses for this cash is improvements that help increase or secure the value of that property.

The three main choices for getting cash out of your property for home improvements are:  a cash out refinance, a second mortgage ( including a home equity loan and a home equity line of credit ) and specialty mortgages such as the FHA sponsored 203K loan and FNMA and FHLMC home loans that are periodically introduced to assist with home improvement financing.  Since the 203K loans are a seldom used product and specialty loans come in and out of favor, these home loan types will not be covered. 

Before discussing the various home loan options it is important how a mortgage lender determines the equity in your home.  The equity in your home is the difference between the value or price of the house and the amount of mortgage loans you owe against it.  A house that is valued at $200,000.00 with an existing first mortgage balance of $145,000.00 has $55,000.00 in available equity.  Though this may seem like a fair amount of equity, a mortgage lender will provide a new home loan for only a percentage of the homes total value not all of the value.  If a homeowner in this scenario were to obtain a cash out refinance for 85% loan to value, the amount of money obtained would be approximately $25,000.00.  This is calculated by taking 85% of the home’s value or $170,000.00 and then subtracting the existing first mortgage balance to arrive at a lendable equity figure of $25,000.00.

Mortgage refinances are one of the most common methods for obtaining cash for home improvements.  Refinance transactions are often 50% or more of all the loans originated across the nation every week with a great deal of variation depending on the level of mortgage rates.  A measurable percentage of these refinance transactions are to extract cash from the property.  This cash is used for an assortment of purposes; most mortgage lenders will tell you almost legal purpose is acceptable for a cash out refinance. 

Fannie Mae and Freddie Mac do not establish rules on the home improvements a borrower may or may not finance with a new mortgage loan.  Therefore an existing homeowner can obtain a cash out refinance to finish the basement, do repairs or add a new room to the structure.  There are no limitations on the minimum amount or maximum amount of financing that needs to be spent on repairs.  If a borrower obtains a cash out refinance to pay for home improvements the main consideration of the mortgage lender is the condition the property is in as well as what the funds will be used for. 

Standard conventional home loans are made based on the existing condition of the property.  This approach results in a standard new home loan qualifying based on the as is value of the property not the as-completed value.  Deferred maintenance is the term mortgage lenders use to describe a property that is in disrepair.  Minor deferred maintenance does not often raise any red flags.  Significant deferred maintenance will usually have to be addressed by the appraiser when they inspect your property.  The appraiser will generally attribute a dollar value to the amount of deferred maintenance. 

If a property is presently in disrepair the mortgage lender will not a grant a conventional loan.  If the property is going to have a significant structural change the mortgage lender may also be concerned about approving the home loan.  Questions may arise as to who is performing the work as well as how and when it will be completed.  Oddly, even though the mortgage lender based the decision on the home loan on the existing property condition and value if a new mortgage loan is going to impact the lenders collateral significantly, they will want to make sure precautions are taken such as a licensed contractor is performing the work.  The improvements should be performed by contractors who are licensed, registered, or certified or have the highest level of certification required.

Other than the limitations on the loan to value for a cash out refinance the structural changes that may be performed, a mortgage refinance is straight forward and the guidelines are the same as they are for a purchase regarding credit, income and debt ratios. 

Home equity loans and second mortgages are also an option and are considered interchangeable terms.  These loans are mortgages you get after you already have a mortgage loan on your property.  There two distinct different types of home equity loans or second mortgages, the home equity line of credit and the home equity loan. 

The home equity loan is generally a fixed rate loan that taken out for a predetermined amount and is disbursed to you at one time.  The home equity line of credit is also a predetermined sum of money but instead of getting the money all at once you are given a checkbook to access the available balance of the loan.  Most all home equity lines of credit are based on a variable or adjustable rate.

These loans will have similar qualifying standards as first mortgages.  The borrower’s income, debt ratios, credit and the amount of the loan relative to the property value or loan to value will be evaluated.  When measuring the loan to value for a home equity loan the mortgage lender will add the first mortgage amount plus the propose second mortgage amount and divide that figure by the home’s value to come with a ratio called the CLTV or combined loan to value.  If a homeowner has a home valued at $200,000.00 with a first mortgage of $125,000 and requests a home equity loan of $30,000.00 the original loan to value is 63% and the combined loan to value will add the home equity loan and would be 78%. 

One of the main disadvantages of home equity loan is the mortgage rate on these home loan products is higher than the mortgage rates found on first mortgages.  A second mortgage home loan is considered to be a more risky loan for a mortgage lender or bank.  The mortgage lender charges a higher mortgage rate over a home loan that is in first position. 

Aside from acquiring the loan you may need, make sure you pay attention to the increased expenses of home remodeling.  Get at least three quotes and stay within a budget.  Taking cash out of your property for home improvements is generally one of the best uses of the equity, often the cost of home improvements do increase the value of your home on a dollar for dollar basis.

There is an ample supply of mortgage lenders that will offer home improvement loans available.  It is up to the homeowner to decide which one is the most suitable for their needs and budget.  The first step should be to find out as much as possible about potential mortgage refinancing, home equity loans and the mortgage lenders.  Utilize the mortgage calculators to help determine debt ratios, loan to values and monthly mortgage payments.  Closely consider important factors such as mortgage rates, and closing costs.  Shop and compare home loans carefully before making a long term commitment.