Home Improvement Loans - A Primer

Home Improvement Loans come in many flavors but they are not equally beneficial to all. Some feature lower rates and tax advantages, while others not so much. Below is a summary of the different loans available along with their pros and cons which should assist prospective homeowners in their quest for a home improvement loan:

Home Equity Loan (HEL): HEL also known as closed-end loans are lump-sum loans, usually with a fixed interest rate based on prime rate plus a margin. The homeowner uses the equity of their home as collateral. As these loans are secured against the value of the property and are usually a second position lien, they are also termed second mortgages.  The loan term can be very short or as long as 30-years although it usually does not exceed the term of the primary mortgage. Except during the bubble years when total loan-to-value levels did not matter, such loans generally require 80% or less.

Pros:
  • Taxes: The interest paid on this type of home improvement loan is almost always tax-deductible.
  • Interest Rate: The rates are favorable when compared to credit card or other personal consumer loan rates.
  • Usability: There is no restriction as to how you use the loan amount. Home improvement and debt consolidation are the more common uses although it can be used for anything including paying for a vacation. While debt consolidation is a popular use, the critical downside is that in essence this converts an unsecured debt to a secured debt.
Cons: 
  • Interest Rate: Although interest rates are lower compared to credit card or other personal consumer loans that are sometimes used as home improvement loans, they have a higher interest rate when compared to the primary mortgage - since the collateral is 2nd lien, the loan is considered more risky to the lender.
  • Recourse Risk: Most home equity loans are considered recourse – the lender can hound your assets, should the collateral (2nd lien on the house) fail to realize enough value to payoff the loan amount in a foreclosure situation. This can become a nightmare especially if the primary mortgage is non-recourse: the much smaller home improvement loan being recourse jeopardizes all of one’s assets for a relatively smaller loan amount.
  • Monthly Payments: As the term of the loan is usually less (20 years is the most common) and interest rates are higher compared to a primary mortgage, monthly payments are higher compared to traditional loans.

Home Equity Line of Credit (HELOC): HELOC or open-ended loans are lines of credit from which the borrower can borrow any amount up to the credit limit during the draw period (typically 5 to 20 years). The interest rate on the borrowed amount is variable although it is based on an index such as prime rate plus a margin. The collateral is the borrower’s equity in the homeowner’s house. Repayment terms are also flexible with a minimum monthly payment requirement. HELOC was trendy among homeowners earlier and viewed as a low cost debt with features allowing flexibility comparable to a credit card debt. The popularity has since dampened somewhat following the mortgage crisis and the HELOC freeze action initiated by many lenders in the 2008-2009 timeframe.

Pros:
  • Taxes: The interest paid on this home improvement loan type is almost always tax deductible.
  • Interest Rate: The rates are favorable compared to credit card or other personal consumer loan rates. Further, when weighed against Home Equity Loans (HELs), variable interest rate is a desirable feature in a prolonged low interest rate environment.
  • Usability: This provides the flexibility to obtain up to the max amount any time during the draw period, in effect making it ideal as a lower cost emergency line of credit.
Cons:
  • Interest Rate: They usually command a higher interest rate compared to the primary mortgage and carry the risk of rising costs in a rising interest rate environment.
  • Recourse Risk: Most home equity loans are considered recourse – the lender can hound your assets, should the collateral (2nd lien on the house) fail to realize enough value to payoff the loan amount in a foreclosure situation. Here again, the possibility of the primary mortgage being non-recourse but the much smaller HELOC being recourse and thereby risking all of one’s assets for a small loan amount exists.
  • Freeze Risk: As the lender can freeze their line of credit at any time there does not exist a guaranteed line of credit with a HELOC.  Many homeowners experienced this unpleasant surprise in 2008 when HELOCs were frozen en masse by many major lenders (Countrywide, Citigroup, Washington Mutual, etc.).
Cash-out Refinancing: Cash-out refinancing is a type of refinancing where the loan amount is more than that required to pay out existing liens, providing the borrower the flexibility to use the balance amount (subject to fees) for any purpose including home improvements. Lender requirements on the loan-to-value ratio determine the amount that can be borrowed. Interest rates are higher compared to the straight rate-and-term refinancing but usually lower compared to home equity loans – the lenders risk is higher as loan-to-value ratio increase.

Pros:
  • Taxes: The interest paid on this loan is tax deductible.
  • Convenience: Since this is a replacement for the first mortgage compared to an additional mortgage with other options, there is just one payment due every month.
Cons:
  • Costs: Compared to HEL and HELOC, loan costs are higher as it is the primary mortgage.
  • Effect of Resetting: In spite of the number of years that has gone into paying the existing primary mortgage, refinancing will reset the loan term thereby extending the mortgage period compared to the existing loan.
FHA 203K Refinancing: This is a combination of the government insured FHA refinance and a home improvement loan. The main differences between this home improvement loan type and other options listed above are that interest rates are generally lower, and the loan value is based on the improved value of the home.

Pros:
  • Taxes: The interest paid on this loan is tax deductible.
  • Higher Loan to Value Ratio: The maximum loan amount can be 110% of the improved value of the home.
  • Interest Rate: Interest rate is lower compared to all other options.

Cons:
  • Availability: Only a limited number of lenders approved by the government do FHA 203K refinancing loans.
  • Use Restrictions: The homeowner is required to do the home improvements pledged when applying for the loan. Also, only certain types of improvements approved by FHA are allowed. Using a contractor can also be a requirement in some cases.
  • Costs: Costs are slightly higher compared to closing costs of a conventional refinance.
  • Private Mortgage Insurance (PMI) Requirement: PMI is required for a minimum of 5 years, independent of the loan to value ratio. With other options, PMI is required only if the loan to value ratio goes over 80%.
Related Posts:
Last Updated: 03/2012. 


1 comment :

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