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Advice from Other Experts:

Many Approaches to Financing Home Improvements

By Jeani Deffina *

Homeowners have tremendous advantages over nonhomeowners when it comes to financing. For the most part, by using a home as security for a loan, almost everything can be financed at lower interest rates than otherwise available.

Using a home as security for a loan means lenders are more secure and can offer loans at lower interest rates. Additionally, there are almost always tax savings associated with using home loans to obtain financing. Because interest paid on loans secured by the borrower's residence is generally tax deductible, the borrower enjoys a lower tax bill as well as a lower rate.

The key in using this powerful tool is in understanding what the alternatives are and how and when to use them. Keep in mind that while equity growth is generally the objective of most homeowners, net worth is a combination of equity in the home plus other assets minus liabilities. Thus it may be advantageous to reduce equity in the home at certain times to reduce liabilities or increase other assets.

Overview of Approaches

When financing home improvements, the borrower can either simply finance the improvement or take the opportunity to review his or her overall financing. Following are some approaches that are popular solutions:

Simply finance the improvement itself by using a home improvement loan for the specific improvement, such as a loan to pay for a swimming pool or a new roof.
Finance the home improvement through an equity line, which allows homeowners to reborrow against the same loan from time to time for whatever reason they choose to do so.
Refinance an existing loan and take out enough cash to pay only for the improvement.
Refinance an existing loan and take out enough cash to pay for the specific improvement as well as other items, such as paying off debt, taking a vacation, buying a car, or making an investment.
Use a combination of the above approaches.

Advantages of a Home Improvement Loan

Now let's take a closer look at the power of financing a home improvement through a home improvement loan rather than paying in cash that could be used for other purposes. Consider the homeowner who wants to add a swimming pool and do some landscaping at a cost of $65,000. The homeowner obtains a 15-year loan at a cost of about $2,500, which is financed in the loan along with the improvement. This means that the homeowner gets the improvement with no out-of-pocket cost.

Following is a look at the true monthly payments. The loan amount is $67,500 ($65,000 for the improvement plus $2,500 in loan costs), and the loan is fixed at 8.75% with a 15-year term. The payments are $675 per month. However, in most cases, the interest would be tax deductible, so there would be a tax savings.

The average annual interest paid in the first five years would be about $5,400. If the homeowner is in a 35% tax bracket taking into account both federal and state income taxes, then each year the $5,400 in interest is offset $1,890 in tax savings, or about $160 per month. This means that the homeowner's true monthly expense is $515 per month for a $65,000 improvement with no cash outlay.

The homeowner could lower the payments even further by using programs that have balloon payments or longer terms. Keep in mind, however, that the overall interest costs would be higher accordingly.

Profile:
Jeani Deffina * is a general manager at Advantage Financial in Danville, California.

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