Publication Date: Wednesday, April 7, 2004

A house with potential
Financing your fixer upper

by Kate Lilienthal

You've finally found your almost-dream home, except it's missing a bedroom or two, a functional kitchen and several shingles from the roof. But what it lacks in shingles -- and space and modernisms -- it makes up for in potential. Expensive potential. So what are your financing options?

To purchase the property, the loan choices are straightforward. They include a fixed-rate mortgage of 15, 20 or 30 years or an adjustable-rate mortgage (ARM). ARMs are fixed mortgages for a set duration, typically 1, 3, 5, 7 or 10 years, after which the rate adjusts yearly with the prime.

Locally, ARMs are currently more popular than fixed-rate mortgages. "On the Midpeninsula, people sell their homes on average every 5.7 years. An ARM is ideal for a homeowner with a short time horizon," said Eric Kinney, loan consultant in the Menlo Park office of Washington Mutual.

Financing the remodel, however, is a whole different bag of nails. Choosing a loan type and completing the application process can require as much creative analysis as the remodel itself.

"The loan that is right for you depends on how long you've owned the property and how much equity has accrued. It also depends on whether you intend to live in the home or sell it immediately," Kinney said.

Most brokerages offer three primary loan options for construction. The first, referred to as a Cash-Out Refinance, allows the homeowner to take equity out of the appreciated value of the home and apply it to the remodel.

For example, if you put 20 percent down on a $600,000-property that over time appreciates to a $1 million-value, you can take out a loan for the principal amount, or $120,000, as well as the appreciated value, or in this case, approximately $550,000. This is the fastest, simplest loan to secure and typically appeals to the owner with a lot of value in a property.

The second option is a construction loan. A construction loan enables you to borrow against the total cost of the construction project or future value of the property once the remodel is completed. This is the most complex of the three loan types and involves several steps to close.

First the property owner and builder sign a contract and the owner applies for a fixed- or adjustable-rate loan. The application process requires several forms of documentation and two appraisals. The builder also submits a builder resume and construction budget, and the owner, builder and loan consultant draft a schedule for disbursements during construction.

In essence, the bank pays the building costs directly. Payments are interest-only while the remodel is in process. The lender also participates in the construction process, checking progress and work quality at regular intervals to ensure the project is on track. "We're just another set of experienced eyes, working to the homeowner's advantage," Kinney said.

While the remodel is in process, owner payments are interest only, but upon completion, the loan is adjusted to reflect the actual amount paid out and regular principal and interest payments begin.

The third type of loan is called a home equity line of credit (HELOC), a credit line equal to or less than the equity value in the house. Mortgage payments on the home equity line of credit begin the first payment period after the credit line is used. Unlike a construction loan, the home equity line of credit does not leverage the future value of the home or the total cost of the project, and therefore doesn't provide as much available money for the remodel. Payments are interest-only and begin the first payment period after the credit line is drawn against.
Additionally, there is a new ARM product now available called an Option ARM. An Option Arm gives a choice of four payment amounts on each monthly statement, allowing you to make minimum payments and free funds for other uses, like home improvements. The minimum payment amount is fixed for the first year, and adjustable yearly after that.

But there's more that goes into buying a fixer-upper than financing. "You and your realtor should carefully analyze the location and understand the market values. You don't want to over-improve for the neighborhood. You might find a fixer upper for $700,000 in a neighborhood in which homes at the upper end sell for $900,000, but if the property you have in mind needs an investment of $250,000 just to be livable or resalable, then it doesn't make sense to undertake the renovations," said Berna Davis, a Coldwell Banker Realtor in Menlo Park.
Davis and business partner Kathy Krize advise clients to do their due diligence when considering fixer uppers. Have a builder check the foundation. Some foundations won't support a second level without reinforcement, a very expensive prospect. Check with the city or county building department to understand how much square footage may be added to the property given the structure's current size and slope ratio.

Also, keep in mind that construction costs often run over budget with unforeseen issues. "Buyers need to carefully pencil out the costs of a remodel and make sure the project makes sense given the neighborhood and their own budget," Davis said.

"Also, think through whether the house is a scraper or a fixer. Check reports for dry rot or structural damage. You don't want to do cosmetic work when the home has structural problems," she added.

A last important question is a personal one. Cautioned Davis, "The homeowner needs to assess whether they can live with a remodel. Trying to get on with the ordinary business of life in the middle of a construction project is very wearing. People need to go into a remodel with eyes open to the toll it takes on daily living."