Home equity loans for home improvments: Reducing your risk

Posted by  on Jun 01, 2011

Using home equity loans for remodeling, renovating and making major property improvements can be a sound investment when you consider the following points:

  1. Your home's current and as-improved values: Hire a local real estate broker to prepare a broker's price opinion of your home. Tell the broker that you're planning a remodeling project and ask for tips on what buyers want in your area. Obtain estimates of your home's current value and its value after making improvements.
  2. Marketability of planned improvements: Determining which home improvements add the most to home value is essential for planning your project. Even if you don't plan to sell your home, the marketability of your planned improvements impacts how much more your home will be worth after improvements are complete.
  3. Neighborhood ambiance and market trends: Woe be to homeowners who mortgage their homes to the hilt only to learn that they've "over-improved" their property. The trick to making home improvements is choosing enhancements that don't exceed those of most homes in your neighborhood. Expanding your home to ginormous proportions amidst a neighborhood of single-story craftsman cottages makes your home look out of place and results in a home unlikely to sell. Home value falls when a home is difficult to sell.

Home equity loans and home improvement: How much to borrow?

Follow these steps for estimating how much you can afford to borrow for home improvements:

  1. Request multiple estimates for your home improvement project. Use a mid-range estimate for planning your home equity financing.
  2. Add 10 to 15 percent to this the improvement estimate for covering cost over-runs, then add the total to the current mortgage balance.
  3. Divide the resulting sum from step 2 by the estimated value after making improvements as shown in the broker's price opinion. The answer is a fraction that indicates the estimated combined loan-to-value ratio (CLTV) after improvements are made.

Here's an example. Your current mortgage balance is $85,000. Your home improvement estimate is $25,000. 15 percent of $25,000 is $3,750. The sum of your current mortgage balance, estimated remodeling costs, and the 15 percent cushion is $113,750. The broker's opinion indicates your home's market value after remodeling would be $165,000. Dividing $113,750 by $165,000 provides a CLTV of approximately 70 percent.

This scenario suggests that after completing improvements, you would retain 30 percent of your home equity. Conventional mortgage lenders typically approve home equity loans at no more than 80 percent CLTV, so making improvements with 30 percent home equity remaining provides a solid cushion of home equity.

Rework the math and/or the scope of your improvement project until you're comfortable with the numbers. Compare mortgage rates for home equity loans; getting multiple mortgage quotes is helpful for finding the best mortgage rates in your area.


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