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Home improvement financing to suit your situation

Michele Lerner | Improvement Center Columnist | January 5, 2015

Financial experts suggest that homeowners set aside 1 to 3 percent of their home value to pay for routine maintenance and repairs, but financing a bigger project such as finishing your basement or remodeling your bathroom requires a substantial investment. Even if you have significant savings, you may feel more comfortable keeping that money invested and borrowing to fund your renovation project. To get started, consult with contractors to establish a budget. Add 20 to 30 percent on top of your estimate to cover unexpected additional expenses that often pop up during home improvement projects.

Next, consider the following financial options that may fit your current situation:

Nearing retirement with adequate home equity

If you're an empty-nester in your early 50s with 25 percent or more in home equity, consider these options:

1. A home equity line of credit. Aside from cash, a home equity line of credit may be your best bet. Not only is the interest you pay tax-deductible, but the interest rate is considerably lower than nearly any type of financing other than a first mortgage. You'll need good credit and a maximum debt-to-income ratio of 41 to 43 percent as well as at least 20 percent in home equity.

2. Cash-out refinancing. If you have enough home equity as well as the credit and income to qualify for a larger mortgage, you may want to refinance and take out some of your equity to pay for improvements. However, consider the impact of increasing the size of your mortgage in the context of your retirement planning. Make sure you can adequately fund your retirement plan as well as make your monthly payments.

Young homeowner with student loans

If you are a new, young homeowner with little equity and a heavy load of student loan debt, these two types of financing possibilities might be the answer:

3. Contractor loans. Many contractors offer to finance your home improvement project, which could be a good option if you don't have other resources. Make sure you do your research before discussing financing so that you know you are getting a fair price for the work and a reasonable interest rate on the finances.

4. Title I Property Improvement loan. The Federal Housing Administration (FHA) insures home improvement loans that are available through many financial institutions. You don't need a lot of home equity to qualify, but you typically do need good credit. The maximum loan amount is $25, 000 for the home improvement and you can use the funds for almost anything other than luxury items.

Limited home equity and years from retirement

If you are in your late 30s and have less than 10 percent equity, this solution might work for you:

5. Borrowing from your 401(k). If you have funds in your 401(k), you can borrow from yourself up to 50 percent of your vested balance or $50,000, whichever is lower. You won't pay taxes or a penalty on the loan, but you have to pay it back, often within five years. Be aware, however, that your employer could demand full repayment within 30 to 60 days if your employment with the company ends by either your or their decision. If you are unable to repay the loan at that time, you are then subject to a 10 percent penalty for an early distribution prior to age 59 ½, and that distribution also becomes taxable income.

Little equity but high credit score

If you have good credit, a high income, but little equity, consider these two kinds of financing:

6. Personal loan. While not all banks offer personal loans, if you have good credit and a good relationship with a financial institution, a loan could be a good option. Generally, personal loans have a lower interest rate than credit cards and a fixed repayment term.

7. FHA 203(k) or Fannie Mae HomeStyle Renovation loan. If you have at least 3.5 percent in home equity, you may qualify for a government-insured mortgage refinance program that allows you to wrap your renovation costs into your mortgage. The FHA 203(k) and Fannie Mae HomeStyle Renovation loan programs have rules about the types of projects you can pay for and require a minimum of $5,000 in improvements. If your improvements are related to energy-efficiency, such as replacing your windows or your heat pump, you may also qualify for an FHA Energy Efficient Mortgage. You can combine this loan with a 203(k) loan to increase your borrowing level.

Before you decide your home improvement project is just a fantasy, investigate the costs and financing options to see if the payments can fit into your budget.

About the Author

Michele Lerner, author of "HOMEBUYING: Tough Times, First Time, Any Time," has been writing about personal finance and real estate for more than two decades for a variety of publications and websites including Investopedia, Insurance.com, HSH.com, SavingsAccount.com, National Real Estate Investor magazine, The Washington Times, Urban Land magazine, NAREIT's REIT magazine and numerous Realtor associations.

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