When you’re planning a remodeling project, start thinking early about how you’ll finance the project. The scale of the project that you can undertake will be directly influenced by the amount of money available. You can complete a Feasibility Study to see if the project can be completed within your budget. If your remodeling plans are ambitious or expensive, you can consider creating a Master Plan to complete your project in phases–perhaps over a period of years.

The four primary options for obtaining financing for a project are: 1) cash; 2) a home equity line of credit; 3) cash-out refinancing and 4) a loan-to-future value loan. Here are descriptions of each of these options.


Financing construction


Cash: Cash is terrific, but even when you have the cash available, you should consider a few points before deciding this is the best option. Interest payments on a home improvement project are tax deductible, but the cost of a remodeling project paid for in cash is not. If you are borrowing money for 3 ½% and are in the 28-33% tax bracket, you are probably paying only about 2 ½%. A second consideration is whether you have other needs for the cash or if you can earn more on your money through another investment with a higher yield.
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Home Equity Line of Credit: A home equity line of credit is a form of revolving credit in which your home serves as the collateral. They are sometimes called second mortgages and they usually don’t involve closing costs. The amount of equity that you have in your home—the difference between the current appraised value of the home minus the amount owed—plays a big part in the bank’s decision on the amount approved for your line of credit. Like other loans, a line of credit has a term—an agreed upon period of time—that the lender will make that set amount of money available. The borrower is not advanced the entire amount up front, but uses a line of credit to borrow sums over time that total no more than the maximum credit limit set by the bank. One of the differences between a Line of Credit and other loans is the interest rate is always variable, which means that it can change over time and is usually based on an index, such as the prime rate. Often the payments required are only the interest due on the loan. The entire amount of the loan is due at the end of the term—like a balloon mortgage. A home equity line term ranges from 5 to 25 years.

Cash-Out Refinancing: A cash-out refinance is a replacement of your first mortgage, so this option does involve new closing costs. With this option, you refinance your mortgage for more than you currently owe and then pocket the difference. Let’s say your home is worth $750,000 and you current mortgage is $300,000. You want to remodel your kitchen and you also need some cash for your child’s tuition, so you’ve decided you need $100,000 for both. With cash-out refinancing you would refinance your mortgage for $400,000, taking the additional $100,000 out in cash and hopefully borrow the money at a lower interest rate than your original loan.

To decide between a cash-out refinance and a home equity line of credit, consider the cost of refinancing your home. The closing costs are usually several thousand dollars. And, it doesn’t make sense to finance a larger amount if the interest rate is higher. If your current mortgage is at a lower rate than currently available, it probably makes more sense to take out a home equity loan.

Loan to Future Value: A loan to future value involves making projections about the future worth of a property after improvements and adjusting the financing arrangement accordingly. The construction loan is converted to a mortgage loan after the certificate of occupancy is issued. The lender will evaluate the impact of property improvements on the value of the land and buildings involved. The extension of the mortgage will be based on whether the lender determines that the amount of the loan will result in a rise in value of the property that is at least comparable to the amount of the loan, including interest and fees.

Once you have a schematic design and a preliminary construction estimate, then you can lock-in the loan amount and interest rate. The bank will pre-approve you for a loan and it is possible to purchase a rate-lock agreement valid through the expected completion of construction. You only pay interest on the construction loan as you make draws. You, the contractor and the lender establish a schedule for draws based on stages of construction. Construction loans are usually variable-rate loans priced at a spread to the prime rate or other short-term interest rates. The full amount of the construction loan is due on completion of construction. The property is refinanced on completion of construction. So, the borrower pays two rates—one for the construction loan and one for the mortgage. During construction, the bank will send an inspector out to check the project at every stage of construction. There are fees for these inspections—usually in the range of $50.00 per inspection, that are paid for by the borrower. The major advantage of this type of loan is that you only have to make one application and have one closing and you can borrow more than would be available to you with a conventional refinance.

Read more about financing in our blog Q&A with John Yannetti of Citizens One bank.

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