The Golden Rules of Borrowing For Home Renovation

Rules of Borrowing For Home Renovation

So, if you must borrow, what are your options? What is the best way to borrow the money?
Here are three rules of borrowing that I’ve found to be helpful.

1. Always spend time looking for the lowest interest rate.
2. If you need low payments, go for the longest term.
3. If you can handle high payments, go for the shortest term.

Top 6 Golden Rules of Borrowing For Home Renovation

Always Spend Time Looking For the Lowest Interest Rate

This is not the no-brainer is seems to be. Sometimes it’s hard to know which of several loans has the lowest rate. For example, you go to bank A and it offers you a three-year loan for 7 percent the first year and 9 percent for the remaining two years. Bank B offers 8 per¬cent for full three years. Bank C offers 12 percent, but there’s no interest charged for the first six months. Which bank has the lowest interest rate?

Before you get out your calculator, be aware that you can’t really tell from the information given above. You need to know more. For example, is the loan amortized (paid off in equal installments) or interest-only? There’s more interest on an interest-only loan because the balance you owe doesn’t decline over time.

Lenders are very tricky when presenting information about their loans. They emphasize the positive of their product, while tending to overlook the negative points. Of course, many people rely on the APR (annual percentage rate) to tell them the true costs of borrowing. Don’t. The APR is no longer a reliable measurement.

The reason is that today creative lenders have come up with all sorts of “garbage” fees that are not covered by the APR. As a result, a loan with a higher APR, but no garbage fees, may actually be cheaper in the long run than a loan with a low APR and lots of garbage fees.

Here’s a simple way to compare loans. When borrowing money from any lender, ask how much the total interest and fees will be for the full length of the loan. For example, if you’re borrowing $10,000 for three years, find out the total interest charged over that time, then add in all the fees for getting the loan.

This is your true cost. Now go to the next lender and ask the same thing for the same amount for three years. When you’re done, simply compare your total loan costs (the true amount you’re being charged). Now you’re comparing apples with apples and can figure out what your true costs are.

If You Need Low Payments, Go For the Longest Term

The longer you pay, the lower your payments. This is simple mathematics. If you borrow $10,000 amortized at 8 percent of your unpaid balance, your monthly payments will be $313 for three years, $203 for five years, $121 for 10 years. Of course, at the end of any of those time periods, you will owe zero.

On the other hand, you can pay interest only. In that case, your monthly payment will be only $67 a month! But you’ll continue to owe the full $10,000.

Many people opt for low-payment interest-only home loans, figuring that price appreciation will cover the unpaid balance and it will all come out in the wash when they sell. Maybe so, but what they are actually doing is trading off a very low payment for reduced equity in their home.

If You Can Handle High Payments, Go For the Shortest Term

This is the corollary of the previous rule. The idea here is to pay off that home renovation loan as quickly as possible. There are many reasons to do so:

– You can borrow the money again for another project.
– You reestablish your borrowing limits.
– You cut out the extra interest you’re being charged for a longer term.

Keep in mind, however, there can be good reasons for keeping a loan and not paying it off.

Get a Loan with Tax-Deductible Interest

Years ago all interest was deductible. Not so today. Interest on credit cards, for example, is not deductible. Interest for personal loans is not deductible.

But interest on a real estate loan, up to certain limits, may be deductible. Generally speaking, when you purchase a home, the interest on the mortgage up to $1 million may be tax deductible. Further, if you refinance, the interest on the refinancing up to $100,000 may be deductible. Certain rules apply, so check with your accountant.

If you can swing it, it obviously makes far more sense to borrow on a loan where you can deduct your interest than on one you can’t.

Be sure, before you borrow, that you can deduct the interest. Don’t relay on the lender’s assertions. Some lenders will say almost anything to get you to borrow and others may simply not know in your situation. Check with a good accountant or CPA who is familiar with your tax situation.

Know Your True Conditions and Costs of Borrowing

Be aware of special loan conditions that may affect you. For exam¬ple, today many home equity loans contain prepayment clauses. They will typically say that if you pay the loan off before three years, you will owe a substantial penalty, sometimes $500 or more.

Also, many home equity loans require that you personally occupy the property. If you rent it out, you may be violating the conditions of the loan, and the lender could call in the entire amount or refuse to lend you more (in the case of a line of revolving credit).

In the case of credit card loans, be aware that the interest rate the lender charges is not regulated (with a very few exceptions in certain states that still retain usury laws). A common practice today is to issue cards with a relatively low interest rate-say, 7 percent. Then the original lender sells your account to another lender that changes the conditions of the account and ups the rate to 20 percent or higher.

Also be aware of all the conditions of your loan: which ones are cast in stone, which ones can be changed, and which ones are most likely to affect you.

And, know your true costs. The true interest rate on the money you borrow, which we calculated above, may be different from your actual cost for borrowing funds.

For example, you may have $10,000 invested in the stock market earning you 11 percent. If you cash in your stocks to pay for a renovation, you lose that 11 percent you would otherwise get. On the other hand, you may be able to get a loan for a true interest rate of 8 percent. By keeping your stock and borrowing the money, you’re actually making a 3 percent profit.

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