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Calculating Your Debt-to-Income Ratio

When considering whether or not you're able to afford the cost of your remodel, a lender is likely to first calculate your debt-to-income ratio. The National Association of the Remodeling Industry provides the following formula for calculating DTI:

Loans Types Pros & Cons

There are a number of options available to you if you're looking to acquire loans or financing for your remodel. Here are some of these options, as well as the benefits and downsides to each.

Please note: This information is for your reference and is in no way meant to replace the advice of a professional. We encourage you to be in touch with a financial advisor or do further research before deciding which option works best for your financial situation.

Home Equity Loans

Home equity loans are the most commonly used method of financing remodels. You withdraw one lump sum that is based on the amount of equity you have in your home.
Pro: The loans are usually repaid with monthly payments, making it easy to budget. Unlike a mortgage, they usually do not come with closing costs.
Con: Interest rates tend to be higher than normal mortgages, and you run the risk of losing your home if you're unable to repay. It's not worth borrowing to remodel a kitchen that you won't be able to use in the long run.

Home Equity Line of Credit

Home equity lines of credit are also based on the equity of your home and function like a credit card. You and your lender set a maximum amount that you're able to borrow from over the course of your project.
Pro: It gives you flexibility by allowing you to withdraw as needed, and you only have to repay the amount that you borrow.
Con: Your interest rate is pegged to the prime rate and is liable to change at any time. Shop carefully and be wary of lenders that may try to lure your with an incredibly low interest rate.

Refinancing

Unlike a home equity loan which leaves your mortgage untouched, refinancing entails taking out a larger mortgage and using the difference to finance your home improvements.
Pro: Interest rates tend to be lower because they are tied to the bond market instead of the prime rate.
Con: Because you're taking out a new mortgage, you also have to pay the closing costs of a mortgage.

FHA 203(k) Loans

FHA loans are loans made by lenders that are insured by the Federal Housing Administration. The FHA covers the cost of the borrower defaults.
Pro: FHA loans have a low (3%) minimum down payment, lower interest rates, and will lend even if you have poor credit.
Con: FHA loans require a Mortgage Insurance Premium which tends to be higher than the Private Mortgage Insurance charged on conventional loans. There is also a limit to the amount that can be borrowed.

Margin Loans

Margin loans allow you to borrow against any securities that you may own. After home equity loans, margin loans are the cheapest option. Depending on the borrower, you may be able to borrow up to 50% of the value of your stocks and 90% on U.S. Treasury securities.
Pro: Interest rates on margin loans tend to be very competitive. You can also deduct the interest against investment income.
Con: If the value of your stocks fall, you're responsible for the difference and will have to put more money into your account. If you don't have the money, you may be forced to sell your stocks when the market is low.

Personal Loans

If you have stocks, bonds, CODs, savings accounts, or other assets, you're likely to find a lender willing to give you a personal loan.
Pro: You may be able to find personal loans with a pretty low interest rate. You also avoid the costs and fees associated with taking out a mortgage.
Con: Though you may be able to find low interest rates, the interest is not tax-deductible.

Retirement Plan Loans

Based on your place of employment and the retirement plan you have available, you may be able to borrow against it.
Pro: Usually you're able to borrow up to half the balance, or $50,000.
Con: Loans against retirement plans have to be repaid within about 5 years, or if you terminate employment. The interest is also not tax deductible.

Life Insurance Loans

You can also take out a loan against a whole-life or other cash value insurance policy, and the death benefit is reduced by the amount of the loan.
Pro: Loans against life insurance policies are usually simple and relatively quick. You can borrow a significant amount of the cash value of the policy and create your own repayment plan.
Con: You'll have fewer assets to borrow against in the case of an emergency, or, if you pass away, your heirs will receive fewer assets.

Credit Card Loans

You also have the option of using a credit card to finance your remodel.
Pro: It's relatively simple if you have decent credit, and it's a fast way to get funds if you're in a pinch.
Con: This is the most expensive borrowing option as interest rates tend to be very high. This should be used only as a last measure and only if you're sure that you'll be able to repay within a short amount of time.

Choosing a Lender

For home equity loans or lines of credit, start with your own bank or credit union. These lenders tend to offer lower rates to loyal customers. However, do shop around to be sure that you're receiving the lowest possible rate.

Mortgage brokers are your best bet when choosing a second mortgage, refinancing, or an FHA 203(k) loan. Brokers have more loan sources to choose from and can give you a wider range of options. Be sure to find a broker with good references.

Sometimes, Contractors will offer financing for remodels. However, this can get very complicated very quickly. Choose carefully, and be sure to reference sources like the Better Business Bureau to be sure that you're working with a reputable contractor. Be wary of contractors who place more emphasis on the monthly payment than the total cost of the job.

Know your rights. The Truth in Lending Act requires that terms, interest rates, and other costs be disclosed to the borrower. Be suspicious of lenders who try to talk around or hide information pertaining to fees.