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There are several ways to pay for your project with the simplest being out of pocket, but with the cost of borrowed money at historically low rates and project costs rising, the most common method to pay for a residential remodel is through a lender. |
A Shifting Pattern
Several years ago, before rates went to historically low levels, most projects were funded with personal funds - personal savings or home equity lines of credit. Rarely did we navigate the financing gauntlet or the appraisal process to secure a construction loan.
However, with interest rates being historically low for an extended period, it has become increasingly common for homeowners to pursue financing to pay for their project.
If financing a project there are two common types of financing available to homeowners, a Home Equity Line of Credit and a Construction Loan.
However, with interest rates being historically low for an extended period, it has become increasingly common for homeowners to pursue financing to pay for their project.
If financing a project there are two common types of financing available to homeowners, a Home Equity Line of Credit and a Construction Loan.
Ask your builder for lender recommendations
Often you can benefit from the relationship and history your builder has with a particular lender.
Often you can benefit from the relationship and history your builder has with a particular lender.
Home Equity Line of Credit
Establishing a Home Equity Line of Credit [HELOC], where you are given access to a percentage of the equity in your house, is a fairly painless and straight-forward process. The maximum allowable amount a homeowner may borrow is set by three key factors:
> Appraised Value
Your home's current market value is an estimate of what you home might sell for. When applying for financing, this value is determined by an appraiser. A professional appraiser will provide comparable market data reflecting what homes similar in size and features are selling for in your area.
> Mortgage Amount
This is simple - it is the amount you still owe on your mortgage. If you don't know, you can check with your mortgage company.
> Loan-to-Value Ratio
A Loan-To-Value Ratio, also referred to as an LTV Ratio, is a comparison between the value of your loan and the value of your home. To determine your LTV Ratio, your lender will divide your loan amount by the home’s appraised or market value. In this equation, a lower value is better. The LTV % is a cap, and determines the maximum allowable funds that can be borrowed.
The LTV Ratio equation looks like this:
Mortgage Amount / Home's Market Value = Loan-to-Value Ratio
Lenders will evaluate your LTV ratio while they are underwriting your loan.
In general, borrowers with lower loan-to-value ratios will qualify for lower interest rates than borrowers with higher loan-to-value ratios. Borrowers who have a lower loan-to-value ratio are considered less risky to lenders because they have more equity in their homes. In the eyes of a lender, borrowers with a lower loan-to-value ratio, and thus more equity in their homes, are less likely to default on their mortgage. Even if they did default, the lender would have a better chance of selling the home in foreclosure for at least as much as they are owed for the mortgage.
During the real estate boom in the late '90s and early 2000s, it was not uncommon to see LTVs pushing 90%. Obviously, that's not the case today. More commonly, a LTV Ratio ranges from 65% to 75%, and at times may reach 80%.
To illustrate, consider the following example. Let's assume that based on an appraisal, the market value of your house is established as $350,000. Your current mortgage has $150,000 remaining. Your bank's underwriting guidelines allow for a Loan to Value Ratio of 75%. Let's see what that gets us.
With a LTV of 75%, the maximum amount of total loans allowed on the property is:
$350,000 X 75% = $262,500
Subtracting the current mortgage amount of $150,000, we have a balance of funds to be borrowed:
$262,500 - $150,000 = $112,5000
In this example, you would be allowed to borrow up to an additional $112,500 to pay for your home improvement project.
> Appraised Value
Your home's current market value is an estimate of what you home might sell for. When applying for financing, this value is determined by an appraiser. A professional appraiser will provide comparable market data reflecting what homes similar in size and features are selling for in your area.
> Mortgage Amount
This is simple - it is the amount you still owe on your mortgage. If you don't know, you can check with your mortgage company.
> Loan-to-Value Ratio
A Loan-To-Value Ratio, also referred to as an LTV Ratio, is a comparison between the value of your loan and the value of your home. To determine your LTV Ratio, your lender will divide your loan amount by the home’s appraised or market value. In this equation, a lower value is better. The LTV % is a cap, and determines the maximum allowable funds that can be borrowed.
The LTV Ratio equation looks like this:
Mortgage Amount / Home's Market Value = Loan-to-Value Ratio
Lenders will evaluate your LTV ratio while they are underwriting your loan.
In general, borrowers with lower loan-to-value ratios will qualify for lower interest rates than borrowers with higher loan-to-value ratios. Borrowers who have a lower loan-to-value ratio are considered less risky to lenders because they have more equity in their homes. In the eyes of a lender, borrowers with a lower loan-to-value ratio, and thus more equity in their homes, are less likely to default on their mortgage. Even if they did default, the lender would have a better chance of selling the home in foreclosure for at least as much as they are owed for the mortgage.
During the real estate boom in the late '90s and early 2000s, it was not uncommon to see LTVs pushing 90%. Obviously, that's not the case today. More commonly, a LTV Ratio ranges from 65% to 75%, and at times may reach 80%.
To illustrate, consider the following example. Let's assume that based on an appraisal, the market value of your house is established as $350,000. Your current mortgage has $150,000 remaining. Your bank's underwriting guidelines allow for a Loan to Value Ratio of 75%. Let's see what that gets us.
With a LTV of 75%, the maximum amount of total loans allowed on the property is:
$350,000 X 75% = $262,500
Subtracting the current mortgage amount of $150,000, we have a balance of funds to be borrowed:
$262,500 - $150,000 = $112,5000
In this example, you would be allowed to borrow up to an additional $112,500 to pay for your home improvement project.
Don't get creative, financially speaking
If possible, work with a lender who routinely writes construction loans and has them as an established part of their portfolio.
Construction Loan
Another construction financing option is a Construction Loan. Unlike a HELOC, which is limited by the current market value of your home, a Construction Loan is capped by the appraised value of your house at the end of your project.
Appraisal Process
Before any borrowed funds are released, homeowners seeking a construction loan must submit their proposed project to the bank for review. The first step is the appraisal process. An appraisal helps establish a property’s market value – the likely sales price it would bring if offered in an open and competitive real estate market.
There are three main parts to an appraisal:
By law, the appraisal must be done by a third party who has no interest in the outcome of the appraisal. That being said, you are well within your rights to be present [or have a representative present] during the inspection. It's a fantastic strategy, as you are able to more fully articulate and clarify project scope, program, and level of finish.
Rather than relying strictly on construction drawings and specifications, the appraiser now has the project's "story" and can better assess and understand the impact of your project on your house's future value.
Just like a HELOC, with a Construction Loan you are allowed to borrow up to 75% to 80% of the appraised value of your project.
Appraisal Process
Before any borrowed funds are released, homeowners seeking a construction loan must submit their proposed project to the bank for review. The first step is the appraisal process. An appraisal helps establish a property’s market value – the likely sales price it would bring if offered in an open and competitive real estate market.
There are three main parts to an appraisal:
- Inspection - an appraiser comes to the property, inspects it to determine fair market value at the end of the project
- Comparable - an appraiser researches similar homes in your area and compares recent sales to determine market value
- Appraisal Report - an appraiser issues a final appraisal report, using the data gathered from the inspection and comparable research
By law, the appraisal must be done by a third party who has no interest in the outcome of the appraisal. That being said, you are well within your rights to be present [or have a representative present] during the inspection. It's a fantastic strategy, as you are able to more fully articulate and clarify project scope, program, and level of finish.
Rather than relying strictly on construction drawings and specifications, the appraiser now has the project's "story" and can better assess and understand the impact of your project on your house's future value.
Just like a HELOC, with a Construction Loan you are allowed to borrow up to 75% to 80% of the appraised value of your project.
Meet the appraiser at your house for the inspection
Answer any questions and tell the "story" of your project, including unique features, room layout, finishes, and local home sales activity.
Answer any questions and tell the "story" of your project, including unique features, room layout, finishes, and local home sales activity.
Sworn Construction Statement
In addition to the work of the appraiser, another lender requirement is a Sworn Construction Statement from a licensed building contractor. A Sworn Construction Statement is an itemized list of all individuals and companies who will provide improvements, materials, or labor toward the construction project.
This includes bids from subcontractors and suppliers for all labor and specific materials that go into the construction of the project. The person making the declaration signs a paragraph at the end of the document stating that the declaration is made under penalty of perjury.
A Sworn Construction Statement requires close collaboration between your contactor and architect. The scope of work and materials outlined in the Sworn statement is directly based on the drawings and specifications generated and provided by the architect. In its final form, the formal Construction Loan application is comprised of three key elements - the Appraisal Report [appraiser], a Sworn Construction Statement [builder], and the Construction Documents & Specifications [designer/architect].
In addition to the work of the appraiser, another lender requirement is a Sworn Construction Statement from a licensed building contractor. A Sworn Construction Statement is an itemized list of all individuals and companies who will provide improvements, materials, or labor toward the construction project.
This includes bids from subcontractors and suppliers for all labor and specific materials that go into the construction of the project. The person making the declaration signs a paragraph at the end of the document stating that the declaration is made under penalty of perjury.
A Sworn Construction Statement requires close collaboration between your contactor and architect. The scope of work and materials outlined in the Sworn statement is directly based on the drawings and specifications generated and provided by the architect. In its final form, the formal Construction Loan application is comprised of three key elements - the Appraisal Report [appraiser], a Sworn Construction Statement [builder], and the Construction Documents & Specifications [designer/architect].
Construction Loan Attributes
Below are common features and attributes of a typical Construction Loan.
> Once the Construction Loan is approved, a percentage of the funds is made immediately available. The borrower will be put on a bank-draft or draw schedule that closely follows the project's construction stages.
> Construction loans include bank-scheduled monitoring and inspections to ensure not only timely completion of your project but that work progress is commensurate with distributed funds.
> Typically, a borrower will be expected to make interest-only payments on borrowed funds during construction.
> Construction loans are typically short term, with a maximum term of one year, and have variable rates that move up and down with the prime rate.
> Rates on construction loans are higher than rates on permanent mortgage loans.
> Upon completion, the borrower's loan liability will typically roll over into a traditional mortgage, ideally in an arrangement where the borrower pays closing costs only once.
> Of late, lenders have been combining the original mortgage and the construction loan into a single, 30-year loan with one closing, called construction-to-permanent financing. Because of the bank's greater loan-to-value risks in this arrangement, be prepared to put a little more skin in the game.
> Construction loans represent a very small percentage of the overall home loan activity. They're also a bigger risk for the lender. Because of this, construction loans are not aggressively marketed online; you may have to hit the streets for them.
> Regional and community banks and credit unions are typically the best sources.
> Given that for most lenders, construction loans are not part of their core lending portfolio, they tend to be more conservative in their underwriting guidelines. They may also have to be "creative" in how they structure your loan, often requiring you to put more of your own money into the project or charging higher interest rates. The best way to minimize this is to work with a lender who routinely writes construction loans and has them as an established part of their portfolio.
> Given that for most lenders, construction loans are not part of their core lending portfolio, they tend to be more conservative in their underwriting guidelines. They may also have to be "creative" in how they structure your loan, often requiring you to put more of your own money into the project or charging higher interest rates. The best way to minimize this is to work with a lender who routinely writes construction loans and has them as an established part of their portfolio.
Below are common features and attributes of a typical Construction Loan.
> Once the Construction Loan is approved, a percentage of the funds is made immediately available. The borrower will be put on a bank-draft or draw schedule that closely follows the project's construction stages.
> Construction loans include bank-scheduled monitoring and inspections to ensure not only timely completion of your project but that work progress is commensurate with distributed funds.
> Typically, a borrower will be expected to make interest-only payments on borrowed funds during construction.
> Construction loans are typically short term, with a maximum term of one year, and have variable rates that move up and down with the prime rate.
> Rates on construction loans are higher than rates on permanent mortgage loans.
> Upon completion, the borrower's loan liability will typically roll over into a traditional mortgage, ideally in an arrangement where the borrower pays closing costs only once.
> Of late, lenders have been combining the original mortgage and the construction loan into a single, 30-year loan with one closing, called construction-to-permanent financing. Because of the bank's greater loan-to-value risks in this arrangement, be prepared to put a little more skin in the game.
> Construction loans represent a very small percentage of the overall home loan activity. They're also a bigger risk for the lender. Because of this, construction loans are not aggressively marketed online; you may have to hit the streets for them.
> Regional and community banks and credit unions are typically the best sources.
> Given that for most lenders, construction loans are not part of their core lending portfolio, they tend to be more conservative in their underwriting guidelines. They may also have to be "creative" in how they structure your loan, often requiring you to put more of your own money into the project or charging higher interest rates. The best way to minimize this is to work with a lender who routinely writes construction loans and has them as an established part of their portfolio.
> Given that for most lenders, construction loans are not part of their core lending portfolio, they tend to be more conservative in their underwriting guidelines. They may also have to be "creative" in how they structure your loan, often requiring you to put more of your own money into the project or charging higher interest rates. The best way to minimize this is to work with a lender who routinely writes construction loans and has them as an established part of their portfolio.
