Publication Date: Wednesday, April 7,
A house with potential
Financing your fixer upper
by Kate Lilienthal
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
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
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
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
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
"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