Making a financial decision about your home is one of the biggest and most impactful moves you’ll make in your life. In today’s market, with tight housing inventory, rising and volatile interest rates, and a declining economy, it can be hard to know what the best choice is for you and your family. In this blog, we’ll help you weigh your options and decide whether you’re better off buying a new home or remodel your current home.
For many people, the decision of whether to buy a new home or remodel their current home comes down to a financial question. For others it’s more about their long terms needs and objectives. For example, my family and I moved into a more spacious home a few years ago. It’s a great house, but it was built in the 1950’s, so it’s a bit funky, and we added another child to the mix. At the same time, we love our neighborhood and don’t want to leave the school district. So, do we move again, or do we remodel?
Here are a few things I’ve consider as I look at the current real estate market and try to decide between selling or remodeling my home. These questions will help you decide the same.
- How much can I afford to purchase a new home or fund a remodel? Do I need flexibility in how I use my funds?
- How much job security do I have? (This is important)
- Am I looking to move soon, or do I have the flexibility to stay in my current home for a longer period?
- What are my needs and objectives?
- For example, do I need more space because my family is growing, or do I want to update the kitchen so it’s more functional or conforms with today’s aesthetic?
- What are the most important factors you need in a house? What are the high priority projects and what is the best funding option for those projects?
Once you’ve considered these factors, it’s time to start looking at financing options. Make sure to invite your financial planner into the conversation.
Remodeling Your Current Home
Before undertaking any home improvement project, it’s important to consider the cost and potential return on investment. While some upgrades will add value to your home, others may not be worth the cost, especially if you’re planning on selling soon. For example, a kitchen remodel can be a great way to increase the value of your home, but if you’re not planning on staying in the house for long, or if you don’t get to sell the house for the amount you envisioned, you may not recoup the full cost of the renovation.
The same is true for structural changes like adding an extra bedroom. Unless you live in an area with high demand for housing, it’s unlikely that you’ll see a significant return on your investment by adding an extra bedroom, in the short-term. So, when deciding whether to make changes to your home, be sure to carefully consider the costs and benefits before taking the plunge. And most importantly, be realistic about the value of your home. No matter how much money you pour into renovations, there will always be a ceiling on how much your house is worth in the current market.
Before undertaking a huge home renovation (think projects over $10,000-$15,000) you should consult with a trusted real estate advisor to see how the updates could impact your home’s value. They will be able to provide detailed trends of recent sales in your area to help determine how your home stacks up and what updates might maximize the value.
As anyone who has undergone a home renovation knows, even the most well-planned project can quickly go over budget. If you’re considering a major remodel, you may be wondering how to finance, or fund, it. A popular option for many homeowners is to use the property’s equity to finance the project, more details below. A great place to start in your journey is to get your home appraised to find out how much the home is worth and how much equity you have. Once you know the value of your home, you can start shopping around for loans.
1. Home Equity Line of Credit
One of the most popular funding options is to use a home equity line of credit, or HELOC. HELOCs are essentially an adjustable-rate loan that you can draw on as needed. HELOCs are most often offered through banks and credit unions, and you will have to go through an underwriting process to qualify. They have become very popular in recent years because initial terms can be favorable to borrowers – even though they can fluctuate- and it offers flexible repayment terms. As an example, I’ve seen HELOCs where you lock in a fixed rate for the first 2 years, so the payments are manageable and predictable. Whichever option you choose, be sure to compare interest rates and terms before deciding.
One factor I like most about a HELOC is they give you flexibility in how you use the money. For example, if the bank provides you a $200,000 home equity line of credit, you don’t pay interest on that money until you use it. So, if you have a kitchen remodel that cost $60,000 and you use your HELOC, your payment is based only on the $60,000 you used. This will still leave you another $140,000 on other projects and renovations. Also, the interest on the HELOC may be tax deductible if you use the funds to “substantially improve” the home. There are limitations and you should speak with you tax professional to see how it would impact you directly.
2. Cash-Out Refinance
Another option is to take out a cash-out refinance (refi) on your home. This essentially means taking out a new mortgage loan for more than you owe on your current one and using the extra funds to pay for renovations. While this can be a good way to get the money you need, you should know exactly what you’re getting into before taking out a new loan.
A cash-out refinance may come with a higher interest rate than your original mortgage, depending on the mortgage interest market, so it’s important to make sure that the monthly payments will fit into your budget. You can put your home at risk if you are unable to make the payments on your loan, so weigh the risks and benefits before proceeding. Also, you if your project goes over budget and you need more money, the cash out refi won’t allow you flexibility in access excess funds.
Another drawback of a cash out refinance is that you begin to pay interest on the amount of cash you take out right away. If you have a multiphase project, then you will be paying on the amount you borrow starting day one.
3. Construction Loan
Construction loans typically have shorter terms than traditional mortgages. Before you approach a lender, it’s important to have all the details of your project in order. Banks will want to see detailed plans and specifications from an architect or engineer, as well as a list of potential builders and contractors. They’ll also want to know how much money you’re putting down as a down payment, and they may require you to purchase insurance to protect the property during construction. By gathering all this information in advance, you’ll be in a better position to secure the financing you need to get your project off the ground.
4. Personal Loan
If you are sure that your project will be small and there will be minimal surprise expenditures that pop up, you may consider a personal loan, which doesn’t require collateral. Personal loans do, however, bar a higher interest rate. If you’re comfortable with managing your finances a bit closer, you could do a hybrid and fund the remodel with credit cards and pay off the balance with a HELOC, for example. However, your interest rate will be higher, and you may not have enough buying power because of your credit limit, so you’ll need to plan accordingly.
Buying a New Home
There’s no doubt that the current state of the economy and the housing market has made things more difficult for would-be sellers and buyers. First off, you don’t necessarily have an extra few hundred thousand dollars sitting around to put as a down payment for a home. Or, if you’re thinking about selling your home to purchase a new one, you may be wondering if it’s even worth it. After all, if your house doesn’t sell right away, you could be stuck making two mortgage payments. This means that if buying is your top choice, you must make sure to be prepared to be flexible by pricing your home competitively.
Another consideration is timing. Over the past few years, homes were flying off the market with multiple offers at or above the asking price. Today’s market is presenting more challenges. Prepare to allow for a longer time frame than you may have originally anticipated and keep in mind that although the real estate market has cooled down in recent years, it is still significantly higher than it was a decade ago. As a result, selling a house now and buying a new one later may not make financial sense.
Contingent offers, for example, where the sale of the buyer’s house is contingent on the sale of their own home, are also not as attractive to sellers as they once were. Of course, there are always exceptions to the rule. If you’re able to find a great deal on a new home and you’re confident that you can sell your old home quickly, then buying before selling may make sense for you.
Also consider that with rates being expected to increase even further over the next few months, it’s likely that we’ll continue to see a slowdown in the housing market. Higher rates make it more expensive to borrow money for a home purchase, and that will price some buyers out of the market. In addition, higher rates also make it more difficult to refinance an existing mortgage.
So, if your idea was to buy a house today to refinance it later, you’ll need to plan accordingly and be prepared to face risks. Keep in mind that the value of your home could decrease by the time you attempt to refinance, leaving you at a point where you would not be able to get a new loan or with an existing loan that is larger than the value of your property. This situation is often referred to as being “underwater” on your mortgage, and it can put you at serious financial risk if it’s not managed well.
The type of mortgage you qualify for will depend on things such as your budget (affordability), credit health, employment history, income and liquid assets, and your debt-to-income ratio. Before you start looking at houses, you’ll need to pre-approved for a loan amount. Let that dictate which houses you consider as you start your search.
Here are the different types of loans that are available to you when purchasing a home.
Conventional Mortgage Loan
A conventional mortgage loan has a fixed interest rate and monthly payments. I’m sure most people reading this are familiar with the basic of these loans. The challenge with a conventional mortgage is the significant increase in rates since early 2022. These increases have put another dent in home affordability. An original mortgage balance of $500,000 at 3% interest, similar to what we saw in early 2022, would result in a payment of roughly $2,108. Fast forward, a rate at 6.75% on the same amount borrowed would result in a payment of around $3,242. This is over a 50% increase in the mortgage payment. We have not experienced such a dramatic increase in rates over a similar period in history. For most, a conventional loan is the most practical type of loan.
Adjustable-Rate Mortgage (ARM) Loan
An adjustable-rate mortgage loan, or ARM, typically has a lower interest rate but can increase over time. The interest rate on the loan will adjust over time relative to the interest market. As those rates change, your rate can change, meaning that you may buy the house paying $2,500 as your monthly payment, and then a year later be obligated to pay $3,200 as your monthly payment. It all depends on the state of the economy and interest rates.
A typical structure is a 5/1, 7/1, or 10/1 ARM. The first number is how long the initial rate is fixed, like 5 years on a 5/1 ARM. The second number is how much the rate can increase each year. So, a 7/1 ARM would be fixed for seven years, and it could increase by no more than 1 percent in a given year.
ARMs can be a good option for buyers if they expect to be in their home for only a short period or if they expect rates to be lower at the end of the fixed rate period. In today’s interest environment an ARM may be a good option because it can provide you a lower interest rate than a conventional loan. However, they can expose you to greater interest rates risk, or the risk that rates will go up.
This includes loans such as FHA or VA loans. These loans typically have lower interest rates and down payment requirements than traditional mortgages. With that, they may require mortgage insurance and qualification requirements.
Before making any final decisions, be sure to do your research and talk to a financial planner that can help you understand the application process and find the best option for your needs. There are plenty of resources available to assist you in making the best decision for your situation. Once you get preapproved for a mortgage, you can work with your real estate agent to find homes that meet your needs and your budget.
Home ownership is a major financial decision, and it’s one that should not be taken lightly. There are a lot of factors to consider, from the initial purchase price to the ongoing costs of maintenance and repairs. If you’re feeling overwhelmed by the prospect of making a financial decision about your home, please don’t hesitate to reach out to me. I’ll be happy to answer any questions you have and provide guidance based on my own experience as a homeowner. Together, we can figure out what’s best for you and your family.
Advisory services are offered through CS Planning, Corp., an SEC registered investment adviser
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