How to fund that major remodel

After 11 years in their Annandale, Virginia, home, Mike and Cherie Jacobs were ready for something bigger and better. But sacrificing their super-low mortgage rate to pay for this was out of the question.

When the Jacobses bought their 1974 house in 2003 for $452,000, they took out a 30-year, fixed-rate mortgage at an annual percentage rate (APR) of 5.25 percent. In 2010, they refinanced, converting to a mortgage with a 4.25 APR. Three years later, they refinanced again, this time acquiring a mortgage with a 3.125 APR.

In 2014, when they explored options for moving or remodeling, prevailing interest rates for 30-year, fixed-rate home mortgages were 4.5 percent, says Mike Jacobs. Taking out a new mortgage would mean “a big loss of a good rate,” he says.

To keep their prized mortgage, Mike and Cherie determined to stay put, adding onto their four-bedroom, 2,550-square-foot home and remodeling existing spaces. Last summer, they asked Schroeder Design/Build in Fairfax, Va., to propose a remodeling design. At the top of their wish list were an upstairs laundry room; a spacious, well-appointed kitchen; and a new master bedroom and bath suite, including a remodeled bathroom and a new bedroom over the garage. The Schroeder team, led by general manager Andrew Schroeder, presented a preliminary design that included these features as well as a remodeled entryway and upgraded main floor spaces and bathrooms.

The estimated cost was $165,000.

To pay for large remodeling projects such as this, homeowners often take out a construction or renovation loan, which entails refinancing with a mortgage that reflects the house's estimated value post-remodel. Many lenders provide mortgages that cover up to 80 or 85 percent of the remodeled home's value.

The Jacobses had no problem convincing prospective lenders of the wisdom of retaining their low mortgage rate. Amit Kaim, vice president and senior loan officer with Atlantic Coast Mortgage in Fairfax and one of the lending professionals they consulted about financing the remodeling project, says, 3.125 percent “is a superb rate. I would want to keep it, too.”

The couple talked to several lenders and scoured the Internet for financing options they liked that would safeguard their existing mortgage. Eventually, they found a solution through Mike's credit union, obtaining $65,000 via a home equity line of credit (HELOC). They also borrowed $50,000 from Mike's 401(k) retirement plan, a move some financial experts strongly discourage.

Because the $115,000 in funding fell short of the $165,000 needed, Schroeder trimmed the remodeling estimate to around $125,000 by eliminating the master bathroom remodel, built-ins for the master bedroom walk-in closets and a few other things. Mike and Cherie tapped into savings to supply the remaining $10,000 of the estimated remodeling cost not covered by loans.

As construction started, Schroeder discovered that the house needed a new roof, gutters and gutter guards — a $10,000 hit to the budget. In addition, the county required that a hard-wired (rather than battery-powered) smoke alarm be installed for every bedroom and each floor. To cover all this plus a few improvements that they chose during the remodel, the Jacobses took out a $25,000 personal loan.

Before ruling out mortgage refinancing, Ken Sonner advises homeowners to look at the whole picture. Sonner, secretary/treasurer of the Mortgage Bankers Association of Metropolitan Washington and senior vice president of mortgage banking at Old Line Bank in Bowie, Maryland, says: “Mortgage interest rates have been very favorable over the past five years.” Factoring in the low rates and a reduction in refinancing costs, homeowners might be “replacing low with low” if they refinance, he says. Sonner adds that the construction loan option may prove to be less expensive than moving to a new home, once all the costs involved in moving are calculated.

But there are numerous options to pay for a home remodel without refinancing the mortgage. Lending caps vary, and a range of borrowing terms may be available from different lenders, so it pays to shop around. Assembling funds from multiple sources, as the Jacobses did, can be helpful. It is advisable to consult with lending professionals and tax experts when evaluating financing options.

Home equity loans and HELOCs make funds available to homeowners using their home as collateral. Sonner says that home values are rising, which has increased the amount of money homeowners can obtain through these channels.

A home-equity loan, or second mortgage, may be an option if the home is worth more than the amount the owners owe through their first mortgage. Money borrowed through a home-equity loan is provided in a lump sum. Closing costs apply. The homeowners must immediately begin paying off the loan in monthly payments; usually the interest rate is fixed. The loan must be repaid within a set period of time. Interest payments may be tax deductible; ask a tax consultant.

A HELOC is more flexible than a home-equity loan. Once the line of credit is established, the homeowners can borrow at any time during the draw period specified in the HELOC agreement, and can borrow any amount up to the maximum credit limit specified. Closing costs are assessed. The HELOC lays out a repayment period for borrowed funds plus interest due. Generally, the interest rate on money borrowed through the HELOC is variable, so that monthly payments may fluctuate. Rates are linked to the prime rate. As with a home-equity loan, a tax consultant can determine whether the interest payments are tax deductible.

Mark Rodgers of Citibank says Citi HELOCs have a five-year draw period, during which borrowers may make interest-only monthly payments. They have 20 years to repay the balance of the principal and interest.

HELOC lenders base the credit limit on several factors, commonly including 80 percent of the home's appraised value minus the balance owed on the mortgage. In 2014, the Jacobses owed about $280,000 on their mortgage. Through their credit union, they were able to obtain a $65,000 HELOC based on 90 percent of the home's value. They can draw on this line of credit for 15 years and have 20 years to complete the repayment. The variable interest rate is prime minus a half percent. Because the Jacobses are using the money for home maintenance and improvements, the interest is tax deductible. As long as they keep the HELOC for more than one year, they owe no closing costs.

Mike says it took about a month to finalize the HELOC, as an older, bank-issued HELOC based on an 80 percent loan to value had to be paid off as part of the process.

Using money from a 401(k) tax-deferred retirement plan may be tempting, but it's not without caveats. Withdrawing dollars from a 401(k) has different consequences than borrowing the money. Early withdrawals from a 401(k) are subject to a 10 percent penalty and tax payments. Borrowing from a 401(k), on the other hand, is permitted without penalty or direct taxation so long as the money is repaid as required.

One benefit of borrowing money from your 401(k) is that you gain quick access to the money, at relatively low interest rates — often based on the prime rate plus 1 percent. In addition, the interest you pay on the loan goes into the 401(k), so it basically contributes to your plan. However, not all 401(k) plans allow funds to be borrowed. Another consideration is that money borrowed comes out of the 401(k) account, where it would have earned interest and might have performed well as an investment. And you will pay tax twice on what's borrowed — once when you use your after-tax wages to repay the loan, and again after you retire and draw money from the 401(k).

After analyzing the pros and cons, the Jacobses decided it was worthwhile to use 401(k) money to remodel — and increase the value of — their home. Mike, who is 48, was allowed to borrow up to half the amount in his 401(k) retirement fund, with a maximum of $50,000. To supplement the HELOC loan, he borrowed $50,000 from his 401(k), at 3.25 percent interest. No closing costs were assessed. It took about two weeks to arrange this loan.

Loans from a 401(k) must be repaid within five years or up to 60 payments, and within 60 days if the employee leaves the employer. Mike has no plans to change employers; he is repaying his loan in 2½ years, via twice-monthly deductions from his paycheck.

Custom credit lines and personal loans

Rodgers says qualified borrowers may be able to arrange a custom credit line up to $25,000, with a variable interest rate indexed to the prime rate. Pricing is based on the customer's profile and Citi relationship at the time of application; the loan is unsecured, meaning it does not entail collateral. There are no closing costs for this credit line. Payments are based on the outstanding balance each month plus applicable interest and any fees.

Qualified applicants may be able to borrow up to $50,000 through personal loans, which are unsecured. The loans are for a fixed term (between 12 and 60 months), have a fixed interest rate, and are repayable in equal monthly installments.

Banks, savings and loans, and other lenders may offer these loans; the Jacobses obtained their $25,000 loan through their credit union, finalizing it in a week.

Since these no-collateral loans are riskier for the lender, they often have high interest rates. The Jacobs loan carries a 7.9 percent interest rate. They have five years to pay off the loan. Once their 401(k) loan is paid back, “2 1/2 years or so from now,” Mike says, “we can focus on paying off the personal loan sooner than the five years.”

Here are some other financing options:

— FHA Title 1 loans: The Federal Housing Administration (FHA) Title 1 program makes it possible for homeowners to borrow as much as $25,000 for home improvements. Banks and other lenders that are approved to do so can make Title 1-insured loans. (An FHA 203(k) loan can cover home improvement work, too, but is rolled into the mortgage, so it would necessitate a mortgage refinance.)

— Financing through contractors: Some contractors can assist homeowners in obtaining financing through lenders with whom they have established working relationships. Companies that install products such as windows, doors, roofing and siding may offer financing as well. The interest rates and terms should be checked.

— Security backed lines of credit: Homeowners with substantial investment portfolios — $200,000 and more — may have the option of obtaining a line of credit backed by their own investments. Called a Securities Backed Line of Credit (SBL), this revolving line of credit may make a larger amount of money available than can be obtained through a HELOC; the credit amount depends on the amount and type of investments.

John Young, a portfolio manager at UBS Financial Services, Bethesda, says the interest rates for SBLs usually are based on the international London Interbank Offered Rate (LIBOR), and tend to be relatively low compared with other forms of credit. Tax deductibility of the interest paid on SBLs varies; consult a tax professional. SBLs may not entail appraisal fees or closing costs.

Mike and Cherie have been enjoying everything about their upgraded home since their three-month remodel was completed in October.

“I love it,” says Cherie.

The old laundry area by the kitchen is now a coffee bar; the new upstairs laundry room/crafts room is convenient and versatile; and the spacious new master bedroom over the garage captures tranquil, treetop views.

Though built-ins in the master bedroom and walk-in closets were not part of the scaled-down project, the couple installed prefab storage units on their own.

With the loan repayments, “we're a little stretched,” says Mike, so additional home improvements are on hold. But that's no hardship. The Jacobses have a few small projects in mind for later, but “nothing else is pressing,” Cherie says.