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Remodeling Loans

Choose the right loan for your remodeling project.

Building a new house or remodeling an existing house can be an exciting way to make a home uniquely yours. But, just as the design requires careful planning and consideration, so does the method of financing the construction process.

Here's a step by step process to finance your remodeling project. What type of financing is available? Which is best? What is a remodeling or "rehab" loan? How do they differ from other mortgage loans? What are draws? How does the draw procedure work?

When remodeling an existing house, the loan options are even greater. You can do a construction only loan or a construction/perm loan as described above. Since you have an existing house, you can also use a second mortgage or equity line of credit to finance your remodeling. Many lenders will allow a second mortgage up to 100% of your homes value. The mortgages can extend over twenty years, thus keeping your payments to a minimum.

Second mortgages and equity lines of credit are different. A second mortgage allows you to borrow a fixed amount of money for a fixed period of time and usually at a fixed rate. Home equity loans are like credit cards. You can borrow and pay off and borrow again up to your credit limit. The interest rates on home equity loans are usually quite high compared to second mortgages. Thus, for purposes of home improvement, the second mortgage is preferred.

Now that we understand how we can finance our project, lets look at the mechanics of the loan. With a construction loan, the appraiser will look at the value of the lot you will build on. He will then add the cost of constructing the house. He will also compare the value of the finished house to others in the area. Generally, the cost to build and the sales value should be similar. If not, the sales value will be determine the final value of the house.

Once you have an appraisal, the lender will determine a loan amount based on the appraisal amount. Typically, a lender will make a loan of 80% of the appraised value of the land with the completed house.

Remodeling is somewhat different from construction in that the value of the remodeling does not always increase the value of the house. For our purposes, it will be useful to describe the different types of rehabbing or remodeling. First, there is the addition to the house. Perhaps you want to add an extra bedroom or family room or an "in-law suite" for an elderly parent. When making such additions you want to make sure that they will complement you house and add to its value. A bedroom that is tacked on so that it can only be accessed through another bedroom does not create additional value.

Home additions should be made with resale in mind. Will a potential borrower want to buy your house and be willing to pay a premium for the additional work you have done?

Other forms of rehabbing or remodeling might not take the shape of an addition. Rehabbing an old kitchen or bathroom can add real value to your home. Again, the value it adds will be in direct proportion to the good taste exhibited.

Before starting rehab work, it is a good idea to visit model homes of large builders in your area. Their models will usually reflect the latest trends in home decor. For example, the kitchen might show would cabinets with white on white appliances. That is a good indication that this type of decor is selling.

On the other hand, your improvements might only bring your house up to date or repair years of neglect. However, they will increase the value of your home.

Buy and Renovate

You might also consider purchasing a house with renovation in mind. This is an excellent way to purchase an otherwise unsuitable house. For example because of the scarcity of waterfront property, older homes on the water are frequently purchased with renovation in mind.

Or, if you have your heart set on a pool, you can add a pool later by including the cost of the pool in your purchase loan. While not all lenders will finance future improvements, with a few phone calls you can find one that does.

The lender's appraiser will review your plans and assign a value to your house that will reflect the improvements to be made. Your finished house should be comparable to neighboring homes, or else the cost of the improvements might exceed the appraised value. In such instances the lender will base the loan on the appraised value and you would have funds for the difference.

How do construction and rehab loans work? When the lender makes a loan in an amount greater than the purchase price or appraised value of a house, the lender does not disburse all of the funds at closing. Instead, the lender will hold back the funds necessary to pay for the work to be done. Let's say you want to add a pool and the best estimate you get for a screened pool is from Deep Pool Co. at $16,000.

If you have enough equity in your house, you can probably borrow all the money you need in one lump sum. If the loan is based on the value of the house after the pool is added, the lender will give you "draws" on the loan amount. This means that when the pool contractor completes the first steps of building the pool, the lender will give you or the contractor part of the loan proceeds. The lender will want to assure that all sub contractors have been paid, by requiring paid bills or "releases" be signed by the sub contractors before disbursing a draw.

Typically a pool loan will be funded in three or four draws. The first draw may be for 25% of the cost. This might include digging the hole, removing the dirt, and reinforcing and guniting the pool.

The next 25% might include the rough pool deck, tile and marciting. The next 25% covers the final deck coating, pool pump and finished plumbing. The last draw would include the screen enclosure and a final inspection by the local government officials for conformance with codes.

Building a new house works much the same way. Draws are given as work is completed. The lender will inspect each phase of completion and release a portion of the loan proceeds.

Construction loans and rehabilitation loans share some of common ground. Whether you finance the work through a lender or pay for it with your own money, it is always prudent to disburse your money only as work is completed. It is never a good idea to pay the full amount up front since the incentive for the contractor to perform is greatly diminished. You should also require the contractor to sign a "no lien affidavit" at time of completion of the work. This affidavit helps assure you that all sub contractors have been paid and will not file a lien on the house. A lien is a claim against your property. If a lien is placed on your property you will not be able to refinance or sell your home until you pay off the lien amount. Many times a contractor will hire another contractor to do some of the work. You might not know about this other contractor, but that contractor could still put a lien on your house if he or she is not paid.

Since lien laws may allow such liens to be filed up to ninety days after work has been completed a lien may be filed after the work is finished. Your only recourse would be to sue the contractor and hope you can recover some money. Depending on the circumstances, title insurance may or may not cover the liens.

Because of the complexity of construction and home improvement loans and the potential risk of liens, it is wise to consult with a real estate attorney before entering into a remodeling contract or a construction loan. It is also smart to check out your contractor with other customers and local consumer complaint agencies.

Remember too, that all contractors must be licensed for the type of work they do. And that almost construction work is going to require permits from the city or county. Failure to obtain such permits can result in costly penalties.

About the Author

Gary Crum is a nationally published author with over twenty five years of management experience in the banking industry. He has a BSBA in Human Resources Management from Florida State University and an MBA from Florida Atlantic University.