For Extra Credit, Figure Out Best Finance Option

Once you’ve got the plans, the builder and the desire to remodel, you need just one thing more: money.

Even a relatively minor remodel is going to cost thousands of dollars, and a major project can set you back hundreds of thousands. Unless you’ve got a vault full of cash, you’re going to have to find a way to finance your job.

There are several ways to go. You can save, pay the remodeling cost from income as you go along, sell stocks or other investments, or borrow.

Though it’s wise to save for some of the cost to help cover unexpected expenses during remodeling, saving enough to pay for the whole job, particularly a big one, is impractical. In many cases, it would take so long that your building permits would expire--and so might you. And unless your project is relatively small and your income is relatively large, paying as you go could turn your construction project into a lifetime endeavor.

Many people like the idea of selling other investments to finance a project because it saves them from having to pay interest. But it has a down side: taxes.

If you sell an investment at a profit, you must pay tax on the gain. The size of the tax hit will depend on how long you’ve held the investment, your tax bracket and the type of investment you sold. However, the federal tax cost typically runs between 20% and 40% of the profit.

The hit is even greater in California, which imposes a 9.3% top marginal tax on all types of income, on top of federal taxes. Ouch.

Naturally, any investments you sell aren’t invested and earning money for you anymore, so you also miss out on any future appreciation. That’s called an “opportunity cost.”

If that sounds like a bigger expense than you anticipated, you may consider the other option: borrowing all or part of the cost. Again, there are several ways to go.

Here are a few of the better options:

* A home equity line of credit allows you to borrow up to a set percentage of the equity in your house. That percentage varies by lender, but often amounts to between 90% and 100% of the home’s equity. The money can be used for any purpose, from remodeling to buying a new car. The interest paid on a home equity line of up to $100,000 is usually tax-deductible too, no matter how you use the loan proceeds.

For those with sufficient equity in their houses--equity is the difference between the home’s market value and the balance on your loan--a home equity line can be a cost-effective choice because there are few upfront costs and the interest rates are generally low. For instance, aside from appraisal and title fees, most lenders will charge just a $50 to $75 loan origination fee.

You don’t need to pay interest on the loan until you start to use the cash, which you usually do by writing a check against the account. (You usually get a checkbook automatically with a home equity line.) The interest rate will depend on your lender, your credit score and how much equity you’ll still have in the home. But rates generally run within half a percentage point of the going prime rate, a bit below if you have exceptionally good credit and a bit above if you don’t.

Aside from the low cost and tax deductibility, the main benefit of a home equity loan is that you have control over the cash. No one looks over your shoulder, telling you if you ought to write a check. You’re on your own.

Of course, if you’re not a sophisticated consumer of construction services, this can also be a detriment. That’s simply because you might be able to use a little advice about whether your payments are getting ahead of the work, a savvy remodeler’s no-no.

* Construction loans used to be costly and ponderous. Under the old model, you’d get a short-term construction loan and then have to refinance to a permanent loan when your project was complete. Naturally, you paid points and fees when you secured both the temporary and permanent financing, which made these loans costly and inconvenient, says Jim Fraser, senior vice president of construction lending at Indy Mac Bank in Pasadena.

But the market has changed dramatically in the last few years, partly as a result of a big secondary mortgage lender’s getting into the business and pushing a standardized “one-step” loan, which folds both the construction costs and the permanent loan into one package, with one set of approvals and one set of closing costs. Today, construction loans are only incrementally more costly than home equity loans, Fraser adds.

However, there are two big differences between a construction loan and a home equity loan, and they can make construction loans very attractive to some borrowers. The first is how much money you can borrow.

With a construction loan, the lender doesn’t look just at what your house is worth today when determining how much to lend. Instead, the appraiser looks at your remodeling plans and determines value based on what the house will be worth when the job is complete.

The amount you can borrow will be determined by the appraised future value or the current value plus the cost of improvements, whichever is less, says Amy Marcussen, senior vice president of Countrywide Home Loans in Plano, Texas. That probably will result in the homeowner’s having access to substantially more cash than a home equity loan could provide.

The second issue is oversight. Construction lenders typically want to know whom you have hired. The bank will then check to see if your contractor is licensed (where applicable), whether he or she has a history of consumer complaints, whether he or she has an established relationship with a bank and whether the contractor’s main suppliers have been paid consistently and on time.

The bank also is likely to take a close look at your budget and weigh whether you have factored in realistic costs. If you haven’t, the bank will either turn you down for the loan or suggest that you hike your contingency reserve, a store of money that you can tap if things go wrong or turn out to be more expensive than you anticipated.

“We like to say that we provide another layer [of protection],” says Fraser. “Candidly, we want the borrower to get the collateral [house] finished, quickly and within budget.”

Notably, there are two types of construction loans--those that fold in the first mortgage in addition to the construction costs and those that finance only the construction costs. If you already have a low-rate fixed mortgage, you may not want to fold your first mortgage into the construction loan because your rate would probably increase. However, you may have to look a little harder for a construction lender. Countrywide, for example, offers only loans that include the first mortgage. Indy Mac Bank will do construction loans either way.

* If you are in the process of buying a house that you know needs work, there are a couple of other loans of interest. One called HomeStyle is sponsored by Fannie Mae, a massive secondary mortgage company. Fannie Mae doesn’t make loans directly; it buys loans from other lenders. However, it sets the standards stat

ing how these loans must be set up.

The short version of the Fannie Mae HomeStyle rules: Your total loan amount, including the cost to purchase the house (or land) and make the improvements, can amount to no more than $252,700. There is no minimum loan amount. A home inspection is required to start. The amount of the loan cannot exceed 95% of the value of the home, after improvements.

So-called 203(k) loans are similar to the HomeStyle program but a bit more restrictive. Under these loans, designed for fixer-upper properties purchased by low-income borrowers, lenders will provide a minimum of $5,000 and a maximum that will hinge on FHA loan limits, which vary from community to community.

These loans are designed to handle “health and safety” repairs first, says Vijay Lala, senior vice president for developing markets at Countrywide Home Loans in Moorpark. So, if the roof needs repair, the lender may require that it be done before any other improvements are made. Still, with a 203(k) loan, you can buy and improve a home with as little as 3% of your own money in the project.

What about simply refinancing your house to get cash out? If current market rates are lower than the rate on your existing mortgage and you have plenty of equity, this can be a great idea. But if market interest rates are higher than the rate on your existing loan or if you don’t have enough equity in the house to complete the job, you’d be better served by either the home equity line of credit or a construction loan.

The Internet is packed with sites operated by lenders and mortgage servicing companies. Some good sites offering information on construction loans:

Http://www.fanniemae.com gives information about the spectrum of HomeStyle products as well as a variety of other types of mortgages.

Http://www.indymacbank.com provides data on a variety of loans and has a question-answer section on construction lending.

Http://www.countrywide.com has information about all types of construction, first mortgage and home equity loans.

Http://www.hud.gov is a good spot to check out the qualification requirements, loan limits and other restrictions relating to 203(k) and Title I loans.

Http://www.e-constructionloans.com also hosts a question-answer section explaining the ins and outs of construction loans.

Next week: Managing the job.

For the entire Remodeling 101 series so far--Part 1: Preliminary Digging; Part 2: Preparing a Plan; Part 3: Reviewing the Plans; Part 4: Defining the Details; Part 5: Interviewing and Hiring the Contractor; Part 6: Getting It in Writing; Part 7: Sticker Shock--visit https:// www.latimes.com/remodeling101.

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