So You Want to Add On

If you are contemplating a home addition, small or large, renovation or full-scale pop-top, to a home you already own or are about to buy, there are two overriding financial objectives.

First, to navigate the maze of carts and horses littering the mortgage horizon. How do I finance an addition I haven’t yet built? I can’t build it without the money, but I can’t mortgage it until it’s built.

Second, try to accomplish the financing with the fewest possible trips through the mortgage turnstile. Up-front fees for construction loans are expensive, and even a garden-variety mortgage refinance costs a couple of grand.

Successful paths to these objectives are different for a home you already own as opposed to an addition project on a home you’re about to buy.

If it’s a home you own now, begin by asking your architect, builder, or brother-in-law to ballpark the cost of your idea. There is no other way to start: until you have an approximate cost, you can’t make sense of financing — or feasibility, or economics. Many a kitchen or master bedroom has died in the initial cost phase, and even more master bathrooms (“Honey, at a hundred grand, I’ll live with your shaving elbow in my ear”).

Once you know how much money you need, the review of financing options begins with examining the loan you already have. If you plan a small project, and your mortgage interest rate is close to the current market, the simplest way to proceed is to refinance your mortgage on a house-as-is basis, and extract enough cash to do the work.

However, if you refinanced a $200,000 mortgage down to 6.50% in 1998, and only need $50,000 for a project, do anything you can to protect an interest rate two points below current market: raise the new money by second mortgage, home equity line of credit, margin loan, 401K loan, liquidate an investment, or any combination of the above. There is good, “weighted-average rate” arithmetic to guide the new-money, preserve-old-rate decision.

If you’re planning a big project, say $200,000 in new cost, and your current mortgage is only $100,000 at 6.50%, the higher cost for a big second mortgage or line of credit will demolish the advantage of your current rate. When your project is done, you’ll have to refinance in one $300,000 clunk no matter where interest rates happen to be at the time.

But, how to get the money to do the construction to get to that refinance clunk? Unless you have the cash you’re going to need a construction loan. Construction money is expensive, usually floating at least one percent over prime, and costing at least a one-percent loan fee.

It’s an odd sequence of events, but generally, as soon as you know you’re going to need a construction loan and a refinance at the end of the project, go to a mortgage lender for guidance through the whole construction process, and then to a construction lender.

The reasons to see a mortgage lender before shopping for construction money: you need to know the ultimate refinance loan is feasible; the mortgage lender will need more financial information from you than the construction lender, and can forward such stuff to the construction lender; you can save a little money and a lot of hassle by using the mortgage lender’s appraiser for both the construction and permanent loans; and the mortgage lender will be current on the price versus quality trade-off among local construction lenders.

Construction loans are best found at banks, the source of any short term, high risk, high rate loan (construction loans are high risk because a semi-finished house is lousy collateral). Most mortgage lenders offer construction money, and most banks offer mortgage money (long term, low risk, low cost); however, the products are best bought “un-bundled”, as pitches for “one-stop” shopping are usually better salesmanship than finance. Construction and mortgage lending are two completely different worlds, even at the same institution.

Your conig adjustment at the end. Bythen you will probably have refinanced anyway. The high caps allow the lender to make up for a big mistake inthe first five years; in return, the lender gives you a cheaper first five than tight caps would allow.

Trade away the periodic cap for a low life cap. You can still find some ARM with a life cap in the elevens if you’llshoot craps from year to year.

It is very desirable and very expensive to buy down the margin. Margin is a big deal because it’s a fixed cost ineach adjustment. Breakeven for buydown tends to be three and a half years — when it’s allowed.

Keep your intentions clear about how long you will own the house, how long it may be until the next refinancingwindow, and what the Fed is up to. Don’t ever be tempted into an ARM at a bottom in rates, or frightened awayat the best time- at a high in rates, or rising into one.