As long-time DoughRoller readers may know, my husband and I went about our journey into homeownership in a slightly off-beat way. Long story short: we own a 2,400 square foot duplex in Indianapolis and have no mortgage. But we do have a significant amount of work left to do, nearly three years into the process.
Owning a fixer-upper has been a fun journey for our family, but it hasn’t always been easy. Besides not always having running water and never having central A/C, we’ve also had to figure out how to finance all the repairs our home needs.
I’m happy to say that we’re now well on our way. Soon, we’ll be closing on a mortgage that will allow us to pay contractors to finish the rest of the work on our home.
Going through this process has taught me quite a bit about options for financing a fixer-upper, too. And there are plenty of excellent options out there. Unfortunately, many home buyers and homeowners just aren’t aware of these options. If you’d like to purchase a fixer-upper or renovate your current home, here are four great options to consider:
1. Cash or credit card
I know, cash and credit cards seem like opposites. But for our intents and purposes, you’d use cash or a credit card in similar situations. These are financing options only if the renovations you need to make are low-dollar projects.
You can do many value-adding home renovation projects for a relatively small amount of money. For instance, painting is a cheap way to upgrade the look of your home. Or you could lay a new floor in a tiny bathroom to modernize it. These upgrades could cost just a couple thousand dollars.
In this situation, it probably doesn’t make sense to go through the lengthy second mortgage or refinancing process. Instead, you can either save up cash ahead of time or use a 0% introductory APR credit card to finance your renovation up front.
If you do choose to use a credit card, though, just be absolutely certain that you’ll pay it off before you start having to pay interest.
Cash and credit card aren’t really the best financing options for your renovation, especially if you’re planning several thousand dollars worth of renovations on your home. If this is the case, look to the following three options for a better deal.
2. A second mortgage
According to mortgage lender James Dix, a home equity line of credit (HELOC) or home equity loan can both be decent options for financing minor home renovations. A HELOC is a revolving loan on your home, meaning it works like a credit card where you can spend up the line of credit and pay it down multiple times over the life of the loan. Home equity loans, on the other hand, are fixed-rate, fixed-term loans.
Both of these options are technically second mortgages. If you owe $100,000 on your home, but it’s worth $150,000, you can take out a HELOC or home equity loan for up to 90% (or sometimes 95%) of the equity in your home — so in this example, $35,000. These loans come with a lien against your home so, if you default, the bank will be able to foreclose on your home just as with a regular mortgage.
That can sound a little scary, but using your home as collateral gives you access to lower interest rates. Plus, interest you pay on a second mortgage usually qualifies for the mortgage interest tax deduction, just like interest paid on a regular 15- or 30-year mortgage.
A home equity loan can sound safer, but Dix recommends homeowners look into a HELOC first. This is mainly because interest rates on HELOCs are so low right now. Home equity loans tend to have a higher interest rate.
On the flip side, HELOCs typically have variable interest rates. “The interest rates right now are favorable,” said Dix, “but the interest rate is usually tied to prime. And while prime is low right now, we have every reason to believe that prime is going to go up in the coming years.”
His bottom-line advice for consumers? Don’t take out a second mortgage, especially a variable-rate option, unless you’re able to pay it off within the next three years.
When is it a good option? If you have some equity built up in your home and can pay off the cost of your renovations within a few years, a HELOC might be a good option for you. Since HELOCs usually have very little closing costs, this is also a good option if you know you’ll be in the market to sell soon. You won’t have to worry as much about breaking even on thousands of dollars of closing costs.
If you’d prefer the stability and longer term of a home equity loan over a HELOC, you might consider option #3, instead: it can also help you tap into your home’s current equity, but it’ll likely involve a lower interest rate.
3. Cash-out refinancing
With a cash-out refinance, you’ll refinance your home and take cash out at closing. As with a second mortgage, this option will only work if you currently have equity in your home. Terms vary, but you can typically borrow up to between 80% and 90% of the current value of your home.
With a cash-out refinance, said Dix, “[you’re] going to get a fixed rate, fixed term. You’re going to get low payments because you can go all the way out to 30 years on that.” This can free up cash for you to devote to other things, including investments or paying down higher-interest debt.
On the flip side, you’ll have to pay closing costs on this type of loan. “On a typical refinance,” said Dix, “your [closing costs are] somewhere around $2,200, depending on the lender.” This also varies depending on the cost of your loan, whether you decide to pay points at closing, and other factors. Closing costs on a cash-out refinance can be similar to those you expect to pay when buying a home.
However, there are some cash out refinance options that have no closing costs. In this case, you’re basically rolling the costs you would have paid in closing into a slightly higher interest rate. If you’re not planning to stay in your home long, as we’ll discuss briefly below, a no closing cost loan could be a better option.
When is it a good option? If you’ve got equity built up in your home, but it’s time to renovate, a cash-out refinance can be a very solid option. If you have a decent credit score and maintain 80% equity, you’ll get a good interest rate and avoid paying private mortgage insurance (PMI).
Plus, a cash-out refinance can be a great option for DIYers. Under option #4, you’ll likely be required to pay a contractor for at least some of the renovation costs. With a cash-out refinance, the bank just hands you a big, fat check at closing. You can do with that what you will, whether it’s paying a contractor to upgrade your bathroom or putting in some sweat equity to build a deck.
So, what if you don’t have much equity in your home because it’s desperately in need of repairs? Or what if you’d like to take out a loan on a new-to-you fixer-upper home? In this case, you need to look at option #4.
4. Renovation loans
Renovation loans are products that are built specifically for fixer-uppers. They come in two main “flavors,” which we’ll detail below. But the thing they have in common is that you actually borrow against your home’s future appraised value, which gives you more money to work with for renovations.
I’ll lay out my family’s renovation situation as a case-in-point example.
Right now, our duplex is half-livable. The half we live in is mostly finished, except that it’s not trimmed out, and most of the drywall isn’t painted. The other half, on the other hand, is stripped to the studs and still full of plaster and lathe remnants and coal dust. In this condition, our house is probably work about $35,000. Even though we own it outright, we couldn’t get enough money out of a cash-out refinance to finish the rest of our hefty renovations.
So we’re working on a renovation loan. Recently, an appraiser came to our home, and we handed him a new floorplan (because the duplex will become a single) and a list of proposed renovations. He looked at the home and said that with all the renovations completed, it will be worth about $105,000.
So that $105,000 is what we borrow against. With the loan we’re looking at, we could take out up to 110% of the home’s value, or $115,500 for renovations. That’s much more than we actually need!
This borrowing against the future value of the home works for new buyers, too. Say you find a fixer-upper on the market that’s currently worth $50,000 but would be worth $100,000 when you get finished with it. You could take out one of the mortgage types below for $90,000 — $50,000 to go towards the purchase price of the home and $40,000 to go towards renovations.
Renovation loans, like the other financing options listed above, have their pros and cons. For one thing, according to Dix, “[typically], they’re going to have a little bit higher interest rate, and they’re going to have a little bit higher closing costs.” This is true of both types of renovation loans, and it’s certainly something to consider when shopping for ways to make your fixer-upper dream a reality.
What are the types of renovation loans, and which would work best for you?
Fannie Mae HomeStyle
This option allows you to borrow up to $417,000 for your home. It’s a conventional loan, which means that credit requirements are somewhat strict, and you need a down payment. You can borrow more than 80% of the future value of the home, but you’re better off putting 20% down if possible.
The HomeStyle is the cheaper of these two available renovation loan options. But it does have one major caveat: you can only utilize up to 50% of the home’s future value for renovations.
This knocked out the HomeStyle as an option in our case. Our future appraised value is $105,000, and we have well over $52,500 of renovation costs to cover. But if you can qualify for the HomeStyle, Dix recommends it. The loan comes with better interest rates, and you don’t have to pay PMI if you have at least 20% equity in your home.
The 203(k) program is administered by the FHA, which means that it has lower credit requirements than the HomeStyle conventional loan. However, Dix says that “because it’s an FHA program, it has up front mortgage insurance premiums, and it has a monthly mortgage insurance premium that stays for the entire life of the loan.” The only way to escape paying monthly PMI on an FHA loan is to refinance later.
Still, if you have to make major improvements on your home, the 203(k) may be your only option (as it is ours!). If you’re planning to stay in your home for quite a while in an up-and-coming market, you may be able to recoup the high costs of the FHA. Just be sure to wiggle out of those PMI payments as soon as you can!
The FHA 203(k) loan has two different options in itself. One, a streamline or limited 203(k) will cover up to $30,000 in renovation costs, and renovations cannot include structural or health and safety renovations. The streamline loan is cheaper and easier to administer, since it doesn’t require several inspections during the renovation.
The regular or full 203(k) is more complicated, but it can cover any type of work, including structural renovations. With a full 203(k), the limit on the total mortgage amount varies by location. You can find out here how much you could borrow under the 203(k) loan.
But with a full 203(k), you can use as much of the loan as necessary to cover renovation costs. In our case, our whole loan is made up of renovation costs!
You can also borrow up to 110% of your home’s future appraised value, though this isn’t recommended. Lenders prefer that you stay under 95% of the home’s future value. The 110% limit is a stopgap for homeowners without much equity who need to make essential health and safety repairs in order to stay in their homes.
When is it a good option? If you’re looking to make major renovations, or if your home in its current state isn’t worth much, look into a renovation loan. The ability to borrow against your home’s future appraised value is an excellent avenue for major repairs. Again, though, look into both loan options.
If you can qualify for the HomeStyle, it’ll likely save you some money and some interest costs. If not, the FHA 203(k) is a good choice, and you can always refinance to a cheaper conventional mortgage a few months (or years) after your renovations are complete.
One Caveat: When Should You Renovate
Now that you know how to finance your home renovation, it’s important to understand when you should renovate. Dix said, “The length of time in which [you] plan to stay in the home should be a significant variable as to what kind of loan [you] should do, or should [you] do a no closing cost loan.”
The bottom line here is to think about breaking even. If you’re investing tens of thousands of dollars into your home, but you’ll still have at least 80% equity when you’re done, you could break even really quickly. In fact, you could likely turn around and sell the home, getting your money back out of it immediately.
But if you’re going up to 90% or more of your equity, think long and hard about putting money into renovating your home, especially if you think you’ll sell in the next five years.
Dix recommended checking online to see what renovations are adding the most value in your area, and then focusing on those renovations. “As a general rule,” he said, “kitchens, baths, and adding square footage–that’s where you get the most bang for the buck. . . Your least bang for the buck is the things that have to be done, but they’re not sexy. So roofs, plumbing, electrical, HVAC systems, etc.”
When in doubt, talk to a local appraiser or realtor if your goal is to make your home easier to sell at a higher price.
On the other hand, if you, like my family, are planning to settle into your fixer upper for the long term, make the renovations you want to make, as long as they fit within 80% of your home’s future appraised value. So long as you keep yourself at that 80% threshold, or a little higher if you must, you’re likely making a good investment in your home remodel.