Home Improvement—Whose Money to Use

There are many ways to obtain financing for your home improvement project. Here are just a few (in order of popularity):

Home Equity Loans

These are the most popular loans for home remodeling. They are tied to the equity in your home and may be tax deductible. Most are available at competitive interest rates.
There are two types of home equity loans: line of credit and lump sum. In a line of credit loan, you and your lender set a maximum amount of money that you can draw upon during the course of your project. This allows you the flexibility of withdrawals. You can make your withdrawals as needed, and you are only obligated to repay the amount of money you withdraw, plus interest. However, be aware that the interest rates on line of credit loans are frequently pegged to the prime rate and can change any time prime changes, or even more frequently.
A lump sum or installment loan is a one-time lump sum withdrawal of a set amount, which you repay in monthly increments usually with a fixed interest rate. The sum is based on the equity you have in your home. Equity is the value of your home minus the outstanding balance on any mortgages. The amount of equity required depends on the particular lender program.
WARNING: If you cannot repay a home equity loan, you could end up losing your house.

Refinancing

When you refinance your home, you are in effect obtaining a larger mortgage to pay off your existing mortgage. The excess funds can be used to finance your home improvements. The big drawback is that refinancing often costs between 3-5 percent of the loan amount and can take as long as getting approval for a first mortgage. This type of financing only makes sense if you were already planning to refinance your home or if you can obtain a much lower interest rate than you are currently paying.

No Equity Loans

Some lending institutions offers loans to homeowners who do not have sufficient equity in their homes to get a home equity loan. No equity loans offer a range of benefits and loan amounts and can work as a consolidation loan to lower your overall debt. The big benefit is that these loans usually are tax deductible.

FHA Loans

The Federal Housing Administration (FHA) began Title I financing for property improvements under the National Housing Act of 1934. This program is still available. Loan amounts range from $1-25,000, with no equity required. FHA loans do require additional paperwork and can take more time to secure.

Margin Loans

Loans against securities you own are the next cheapest source of funds after home equity and no equity loans. With a margin loan, some brokers will let you borrow up to 50 percent of the value of your stocks and up to 90 percent on U.S. Treasury securities. The interest rates are also competitive. In addition, you may deduct the interest against investment income (but not against ordinary earned income).

WARNING: There is a risk attached to these loans-if your stocks go down in value, you will be called upon to deposit more money into your account (known as a margin call). If you cannot come up with the money, you will be forced to sell your stocks when the market is low.

Personal Loans

There are many types of personal loans available: debt consolidation; unsecured lines of credit based on your earning capacity or net worth; and lines of credit secured by a possession, such as a car or a savings account. The interest rates for personal loans depend on the borrower's credit and what is used for collateral. For example, loans using savings accounts as collateral may be priced as low as 2 percent above the savings/CD rate.

WARNING: Remember that accounts used as collateral will not be available for other purposes.

Loans from Retirement Plans

You may be able to borrow against a defined-contribution retirement plan, such as a 401(k) or company profit-sharing plan, depending on where you work. The availability and terms of these types of loans will vary from employer to employer. Usually, if a company allows these loans, you can borrow up to half of your vested balance or $50,000, whichever is less. You will be required to repay the loan in full within five years or if you terminate your employment. The interest on these loans is not tax deductible.

WARNING: There are significant IRS restrictions on these types of loans. If you do not follow the rules and restrictions, you may be faced with a 10 percent penalty fee, plus income taxes on the money you borrow.

Life Insurance

If you have a whole-life or other cash value insurance policy, you can borrow against that policy. The death benefit will be reduced by the amount of the loan. If you die before the loan is repaid, your heirs will receive the face value of the policy less the outstanding loan balance.

Credit Card Loans

These are as quick and easy as visiting your local bank. Your credit card will determine the amount of money you can borrow and what interest rate you will be charged.

WARNING: As easy as this is, it is one of the most expensive ways to borrow and should only be used if you need money quickly and plan on repaying the loan just as quickly. The interest rate charged is usually quite high.

Reprinted with permission of (NARI) the National Association of the Remodeling Industry.