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Which option is best for you?
The US housing market has been dominated by two stories over the last 18 months: record low rates and home price appreciation, both of which are destined to cool off. The Fed's bond tapering is likely to begin in November (aka cool off likely) pending the latest jobs report which comes out Wednesday morning (MBS Live). So, where will the next jolt of energy come from in the housing industry? One possibility: Remodels & Renovations.
According to CoreLogic, US homeowners averaged a $51,500 gain in equity from Q2-2020 to Q2-2021. Californians averaged $116,000 in home equity gains.
With property values sky-high, homeowners are taking advantage of their new equity to finance projects on their property, like adding a granny flat (ADU) or building a second unit. Let's break down the three most common ways to finance a remodel along with the pros and cons of each.
1) Pay Cash
If you have an abundance of cash and don't need to liquidate investments or squeeze your reserves, by all means you should remodel with cash! Maintaining a 'cash cushion' is always a good idea to hedge against unexpected events and/or emergencies. Keep in mind that spending your cash will hinder future opportunities that require upfront capital.
You probably have an excellent rate on your current fixed loan at or below 3%. But with rates as low as they are now, you could a) keep your rate the same or b) keep your payments the same if you have a higher rate. If you are ready to start your remodel and want to finance the costs, taking cash out of the equity in your home is currently your best option. With today’s lending guidelines, you can do a cash-out refinance on up to 80% of your home’s value (80% LTV*). For example, let's say owe $500k on your mortgage and your property is worth $775k. We could help you refinance your loan at $620k, with the extra $120k going towards redoing your kitchen, bathrooms, or create the backyard experience you've always wanted. In this scenario, your monthly payment might only increase by $145/month.
3) 2nd Mortgage; HELOC or Fixed Rate
A Home Equity Line of Credit (HELOC) can be a great option to finance renovations. HELOCs work like a credit card, they have a maximum credit amount (typically 85% CLTV*) that you can borrow against, and you only pay interest on what you use. Example: if you owe $600k and your property worth $900k, you could take out a HELOC with an available credit of $165k*. HELOCs are 30-yr loans, the first 10 years is the 'draw period' where you can access the line, simple interest-only payments are required. The next 20 years is the 'repayment period' where access to the line closed and fully amortized payments on the balance are required. HELOCs are tied to the Prime Rate (currently 3.25%) plus a margin (typically 0.5-2.0%). HELOC rates are considerably higher than 1st 30-yr fixed rates, as they are a riskier product. In summary, HELOCs offer I/O payments, and you only pay for what you need. This is your best option if you plan on paying off your balance in the near future.
If you don't want a variable rate and plan on repaying within 10-20 years, a fixed-rate 2nd mortgage could be your best option. Current rates for fixed 2nd mortgages are between 5.5% and 7.5%. Loan term and payments are fixed for the life of the loan (10, 15, or 20 years).
Key Takeaways
There are some things to keep in mind as you plan your next remodel. Remember that county assessors annually evaluate your land AND improvements to determine the total assessed (and taxable) value of your property. Any 'new construction' on your property (requiring a building permit) will most likely force a reassessment of value. For example, adding a granny flat (ADU) could cause this reassessment. Additionally, there are zoning laws that restrict what kind of improvements you can make to property in certain areas. For example, you can not build a multi-use property on what was previously a single-family home.
Renovating or remodeling your home can be an exciting opportunity and a big milestone in your life. Before you get started, make sure you know and understand the critical information and outcomes involved. Contact us today if you have questions about renovating your property, checking your home's value, or refinancing your loan.
* 80% LTV = Loan-To-Value ratio (loan amount / property value)
* CLTV = Combined Loan-To-Value ratio (all liens & loan amounts / property value)
* $210k = $900k x 90% - $600k
Photo: National Mortgage Professional
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