Improve your ROI with the right financing

Homeowners upgrade their houses for many reasons, but almost all of them care about getting a decent return on their investment when they sell. Return on investment, or ROI, is determined by a few things -- the amount a buyer is willing to pay for an upgrade, the cost of the upgrade, and the cost of financing the upgrade. This article explains the different types of home improvement loans and how to get the best deal.

Paying for Home Improvements

There are many methods of paying for home improvements. Home improvement loans can be unsecured or secured by the property. Some require home equity and others do not.

  • Use a credit card. If the project costs are relatively low (a few hundred to a few thousand dollars) paying by credit card might be a viable option. There might be rewards or cash back involved, and if the homeowner can pay the balance off quickly, it might makes sense -- at least there are no loan fees or closing costs. Cards with zero percent introductory rates can give borrowers up to 18 months to pay the balance without accruing interest.
  • Take out a personal loan. Personal loans require no collateral, unlike home equity financing. This means if the homeowner runs into financial trouble, the personal loan can be included in a bankruptcy proceeding and the home is not at risk for foreclosure. Interest rates are quite low for those with excellent credit. Typical terms range from one to five years for amounts of up to $35,000.
  • Borrow with a home equity loan. A home equity loan is a mortgage and is secured by a residence. Most lenders limit home equity financing to 80 or 90 percent of the property value. If Homeowner A has a house worth $100,000 and has a mortgage balance of $60,000, there is $40,000 of home equity. However, if Lender B limits loans to 80 percent, only $20,000 of the $40,000 in equity can be borrowed against. Calculate your home equity to determine how much you could access. Home equity loans can have fixed or variable interest rates. At closing, the homeowner gets a lump sum, which is then paid back over time in monthly installments. There are lender fees and the property may be appraised.
  • Set up a home equity line of credit (HELOC). A type of home equity loan, the home equity line of credit (HELOC) is also a mortgage and also secured by property. Unlike a regular home equity loan, the borrower gets no cash at closing, but can withdraw money when it's needed. The HELOC is a revolving line of credit, similar to a credit card. HELOCs work well for ongoing projects, when the borrower might need to pay as the renovations progress over time. The interest rate for a HELOC is usually variable, which can make budgeting more difficult.
  • Borrow against retirement. Some companies allow employees to borrow against their 401(k) accounts. Interest rates are usually low (you're borrowing from yourself) and there are no fees. However, if the borrower leaves the company, the loan must be paid in full right away, or it becomes taxable, and there is a ten percent penalty as well. Taxes and penalties can easily exceed 30 percent.
  • Take out a Title 1 Loan. Title 1 loans are offered by private lenders but backed by the federal government. They're designed to finance light-to-moderate home rehabilitation projects. Title 1 loans function like home equity loans -- they are mortgages secured by the house. However, one major difference is that Title 1 loans don't require any existing home equity -- the home is appraised at its "improved value" for qualifying purposes. This program can't be used for luxurious upgrades like pools,and the maximum loan amount for a single family home is $25,000.
  • Do a cash-out refinance. If current mortgage rates are better than what the homeowner already has, refinancing to a bigger mortgage and taking the difference in cash is another way to pay for improvements.
  • Choose an FHA 203(k) refinance. This FHA refinance (it can also be used to purchase and rehab a fixer-upper) allows homeowners to upgrade even if they currently have no equity. Like Title 1 loans, the home is given its improved value for qualifying purposes. The old mortgage is replaced by a new one with extra amounts for home upgrades. Loan amounts are limited to FHA maximums and are determined by the property location.

Don't Go Here!

Experts recommend that homeowners not use a contractor for financing -- some of the worst home improvement scams are related to financing activity. Usually, the contractor solicits the business -- sometimes door-to-door, offering low prices because they're "already in the neighborhood for another job." For cash-strapped homeowners, the builder offers to arrange financing. The lender put a lien against the property, the interest rate and fees may be very high, and the builder gets paid right away but doesn't necessarily do the work.