Smart -- and stupid -- ways to pay for your remodel

By Liz Pulliam Weston

Houses can be costly beasts, and not everyone has a pile of cash sitting in a checking account to pay for repairs and improvements.

But if you need to borrow money to pay for major home fix-ups, you should know that there are smart ways and stupid ways to get money:

• The smart ways insure you pay as little interest as possible, get a tax-deduction for what you do pay and don't end up compromising your financial health.

• The stupid ways can leave you house poor -- or even homeless.

To figure out the right financing, you'll need to take a look at your budget, the equity you have in your home, the nature of your project and how long it will take you to pay the money back.

"You need to think about your total financial picture," said financial planner Ross Levin of Minneapolis' Accredited Investors Inc.

Among the questions you should ask:

1. How much will this project cost? Before you borrow anything, have a firm idea of how much you'll need. Use contractor bids as your basic estimate, then add 10% to 20% for potential overruns.

2. Can I afford this? If you can barely afford the minimum payments on the loan, you're getting yourself in over your head. You also could be courting trouble if you're considering a home equity loan or line of credit but you have less than 20% equity in your home. You'll wind up paying higher interest rates and seriously depleting an important financial cushion for emergencies. If the project itself isn't an emergency repair, you may want to put it off until your finances are in better shape.

3. What are my other financial obligations? Before you schedule any non-essential home project, make sure your other financial bases are covered: you're saving enough for retirement and college, you've paid off all credit-card debt and you have at least three months' expenses saved in an emergency fund, for example.

4. Will this project add value? Repairs don't add value -- they simply preserve what you've got. Many home improvements add some value, although you generally won't recoup more than 50% to 75% of what you spend. The less value you're adding, the more you should consider waiting until you can pay cash -- unless, again, you're facing an emergency repair.

5. Can I pay back the loan quickly or will I need several years? The bigger the project, the more likely you'll need years, if not decades, to repay the loan.

6. What's the worst that could happen? Today's adjustable rates have almost nowhere to go but up. If you're taking out an adjustable mortgage or a home equity line of credit with a variable rate, make sure you can afford the payments if rates rise to the maximum level allowed under the loan. (Many home equity lines of credit, which now average around 4%, can rise to 18% or more.) If you can't, consider a fixed-rate loan instead.

Borrowing against equity

Generally, borrowing against the equity in your home -- with a cash-out refinance, a home equity loan or a home equity line of credit -- is the best way to go if you don't have sufficient cash to pay for your project. Here's how they work:

Cash-out refinancing. With this type of financing, you replace your existing mortgage with a larger one and use the extra cash to pay for improvements and repairs. This could be a good choice if:

• Interest rates have dropped since you got your current mortgage

• You'll be in the home long enough to recoup your refinancing costs

• Your project adds lasting value to your home

Home-equity loan. You get a set amount of money, usually at a fixed interest rate, to be repaid over 5 to 15 years. Rates are typically about 1 to 2 percentage points higher than for regular mortgages. Upfront fees and costs are usually minimal. These are good when you need a lump-sum payment and require several years to pay it back.

Home-equity line of credit. These work something like credit cards: you borrow money as you need it and pay a variable interest rate. Rates are usually zero to two percentage points over the prime rate. You can usually establish a HELOC without paying any fees. These are good for smaller projects and those you can pay off quickly.

With all three types of loans, your interest rate will be lower than with most other options, and your interest payments will be tax deductible if you itemize.

The downside: if you fall behind on your payments, you could lose your home. Also, borrowing against your home equity could tempt you to overspend.

Americans are on track to owe a whopping $1 trillion in home equity loans and lines of credit this year, according to SMR Research. That's on top of nearly $100 billion that Freddie Mac says homeowners borrow through cash-out refinancings each year.

This binge of borrowing has some experts worried that Americans are draining away their financial cushion for emergencies and jeopardizing their retirements. (Home equity can be a powerful addition to Social Security and pensions, but not if you spend it all by the time you reach retirement age.)

Continued: A big project may call for a construction loan

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