Home remodeling is an exciting endeavor—dealing with the expenses not so much. According to Realtor.com the starting cost for major renovations averages around $15,000 to $20,000, so it makes sense why many Americans decide to finance their home improvement projects via loans, instead of paying with cash upfront. If you want to save money, make smarter loan decisions, and learn about the basics of home improvement financing – you should keep reading. There are a lot of things to consider before signing the dotted line.
We created this article to give you a better idea of the major factors to consider when financing your home improvement project. By the end of this post, you will know what are the most important questions to keep in mind before you take out a loan. In general, these seven questions will guide you to make smarter financial decisions and find out which home loan option best fits your budget. But, each loan is different. So, be sure to always carefully check the fine print!
1. Is My Home Improvement Project Really Worth It?
Make sure your home improvement goals make financial sense. One common reason Americans remodel their home is to make their property more attractive for the real estate market. For example, say you have an additional guest unit in the backyard that you rent out for $700 monthly. You hope that by adding a kitchen you can increase the rental price and charge 1300 per month. Ask yourself: is that extra $600 of monthly income worth the $20,000 in renovations? It sounds great, but in reality, you need around 4 to 5 years of consistent rental payments to make back your money. Consider this period of time where you will not see any benefit to your income and consider if it is really worth it to take on the large project.
Think about certain rooms or aspects of your home you are investing in. Updating highly desired qualities of the home will bring higher returns on investment. For example, when you invest money into your property’s curb appeal, you can expect to make money back. Landscaping enhancements and a fresh exterior paint creates a strong first impression, ‘wows’ potential buyers, and might boost your property’s value by 5-11%!
2. How Much Can I Borrow?
Before you search for the best loan, you will need an accurate estimate of how much your project will cost. A thorough description of costs will help you understand your total budget, and is usually required by lenders. Once you have your total project estimate, add on about 20 to 30% to find the total amount you need to borrow. These extra expenses are for labor costs, permit fees, and other surprises that are hard to predict. It’s better to be safe than sorry.
How much you can borrow depends on your credit rating, income, and the loan-to-value ratio. In addition, these factors determine the interest rate, the length of a loan, and whether you must pay points (interest paid in advance). The loan to value ratio is a percentage of the market value of your home. The typical limit is around 80 percent of a home. A lender will subtract your mortgage balance from the loan to value limit. For example, let’s say your home is appraised at $200,000. Your Loan to value limit would be $160,000. If you have a balance of $70,000 on your mortgage, the maximum loan you could receive would be $90,000 ($160,000-$70,000=$90,000).
Credit rating also plays an important role in determining how much you can borrow. As with most big purchases, having good credit is helpful. The most desired rates and loan terms go to the homeowners with great credit (this means no recent late payments and no credit lines with lots of debt). If you have great credit, expect to pay lower interest rates and potentially receive a larger loan. The lower the credit score, the more likely you are to have higher fees.
Lastly, your income is the last major factor lenders will consider when giving out a loan. A high income does not necessarily mean a larger loan. If you have debt over 35% of your monthly income, you will most likely face higher rates. How much debt (i.e. credit, mortgage, other loans) you have compared to your income (debt-to-income ratio), helps a lender determine your monthly payments for a loan.
3. Is the Loan Secured or Not Secured?
Always ask if the loan is secured or not. A secured loan means that you agree to give your lender collateral. Collateral is used to protect the lender’s investment they are supporting you with. For home improvement loans, the collateral will most likely be your home. If you cannot pay your loan on time, the lender can potentially foreclose and sell your home to recoup money to pay off your debt. If a loan is unsecured, you will not have to supply the lender with any collateral, and your property is not at risk.
4. What is the Interest Rate?
Interest rates are determined by a number of factors, such as the type of loan, your credit score, loan-to-value ratio, and certain market conditions like federal reserve rates and inflation. Your loan-to-value ratio becomes especially important when you decide to utilize your home’s equity or take out a second mortgage. Lower loan-to-value ratios qualify for lower interest rates.
5. Is the Interest Rate Fixed?
An important but often overlooked question. If your interest rate is fixed, you are guaranteed to pay the same interest rate throughout the life of a loan. Adjustable interest rates are subject to change. If the interest rates increase, so does your monthly payment. On the other hand, if your interest rate decreases, so will your monthly payment. Depending on who you take out a loan with, the interest rate may fluctuate depending on the U.S federal reserve rate.
6. What is the APR?
Annual Percentage Rate is commonly referred to as APR. This is a percentage that represents the actual yearly cost of funds over the term of a loan. APR includes interest rates but also origination, closing costs, and other fees. Knowing the APR gives you a better idea of the total cost of the loan. It’s important to realize that APR and interest rate are not the same thing, sometimes a loan offer may seem great because it has a ‘low’ interest rate— but in reality, hidden fees may increase the loan’s APR and your total expenses.
7. Hidden Fees?
Unfortunately, when you borrow money, be ready to pay unexpected fees. Origination fees are common for most types of loans. These are the fees that cover the lender’s costs for reviewing and processing your loan application. Such fees will most likely be a percent of the amount you intend to borrow. Additionally, you may have to pay application fees and lawyer fees. Fees differ depending on which finance option you choose. For example, using home equity incurs specific costs. When utilizing your home’s equity, a lender may charge you an appraiser fee, as a licensed realtor will need to determine the market value of your home.
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