Financial Aspects of Home Improvements

by Gary Foreman

So it's time to improve the old homestead. You've been collecting pictures of that new kitchen, bath or deck. Now you're ready to move forward with the project. You've considered whether you can afford the remodeling. But there's more than the cost to consider when you take on a home construction project. Let's look at some of the financial considerations of home remodeling.

The first question that you'll want to answer is whether the improvement is for your benefit or to help you sell your home. If you plan on staying in your home you'll want to tailor the changes to your family's needs. But if a higher sales price is your goal you'll want to compare your home to others in your neighborhood. Improvements that bring your home up to the average of your neighborhood add to the sales price. But having the only swimming pool in your area generally won't pay off. Most homes in an area sell within 20% of the average.

You won't want to spend a fortune on improvements if you're moving. But don't skimp too much, either. Shoddy workmanship has a way of showing up at the worst possible time. Remember, too, that tastes vary. You may have visited every store in town to find just the right shade to paint your kitchen. Don't be disappointed if prospective buyers don't approve of your selection. Sometimes bland is better.

The next decision you'll face is how to pay for your project. There are a wide variety of choices available. Depending on how you finance the project you may even be able to deduct the interest from your income taxes. Be sure to seek competent tax counsel because it's not always easy to know what's deductible.

The simplest method is to just borrow the money using an 'unsecured loan'. This type of loan is best when you're dealing with a smaller project (under $10,000). You won't have the loan costs associated with other types of loans. The downside is that the interest rate will be higher.

Another method is to get a 'home equity line of credit'. If your home is worth more than your current mortgage you can borrow against that amount. You'll be allowed to borrow the money in stages as you need it. You can expect to pay 'closing costs' to set up the loan, but no interest will be charged until you actually borrow the money. Interest rates will be variable and you'll need to be able to handle higher payments if rates go up. Also, be aware that under some circumstances the lender can force you to pay all of the money owed immediately. For most of us the only way to pay off the loan would be to borrow it somewhere else or to sell our home.

A 'second mortgage' is another option. It's similar to the home equity loan in that you're borrowing the equity in your home. But a second mortgage is usually for a fixed period of time and often carries a fixed rate of interest. Once again you'll face closing costs. You may even need to buy title insurance and pay processing fees.

'Refinancing' your first mortgage works best if you're doing a major project and the interest rates are lower (2% or more) than your existing mortgage. Once again you'll have closing costs to consider. Make sure to contact your tax advisor since interest may be deductible.

If you have a 401(k) or 403(b) retirement plan, you may be able to borrow against it. You'll avoid most closing costs. This works best for smaller projects since you'll be limited to a fairly short time frame to pay back the loan.

One final option is to borrow the money from your contractor. This is almost always the most expensive way to get money for remodeling. You can expect to find rates in the 20% area.

Now that you know how you'll be paying for your project let's decide who will perform the work. If it's a small project you might want to do the work yourself. There's a great satisfaction in enjoying a home improvement that you did. But remember that you'll need to do a satisfactory job. If you need to buy extra materials or new tools to get it done right, you might not be saving much money. Also remember that an 'in progress' kitchen or bath may not be available for family use. Complaints can be a real irritant when a project's not going according to plan!

If you're going to use a contractor make sure you're set up to pick the right one. The first step is in knowing exactly what you want your completed project to look like. How big will your new room be? Where will the doors and windows be placed? What type of windows do you want? Will the floor be tiled? Carpeted? Who will do the painting? Who buys the paint? You'll want to be as precise as possible so that different contractors are bidding the same project. If your project is complicated you may even want to have an architect draw up plans before soliciting contractor's bids.

Get at least three estimates. Discuss each to find out why it's higher or lower than the others. The lowest bid is not always the best bid.

The Better Business Bureau suggests that you make sure that the company doing the work carries proper insurance. If a workman is injured on your job you could be held liable. Find out which company insures your proposed contractor. Then contact that insurer to make sure that the insurance is still in force.

Once you've selected someone to do the work, you'll need to prepare a contract. The contract is important for two reasons. First, to keep the job on track. If you include an explanation of what you expect many chances for errors and confusion are eliminated. Second, if you have problems with your project a contract can provide solid legal ground to resolve the issues.

Your contract should include both starting and completion dates. The total cost of the project should be stated. A breakdown of material and labor costs can be helpful. You'll want to include a payment schedule.

It's typical to pay about one third of the job when the contract is signed. This allows your contractor to buy materials. The other two thirds should be spread out over the job and be tied to specific parts of the job being completed. The final payment should not be made until final inspection and certificates of occupancy are received.

Also included in the contract are any warranties and guarantees for workmanship. Descriptions of the work to be done with references to specific grades of material, colors and manufacturer's part numbers should also be a part of the signed document.

Two other clauses should be considered. The first is a 'release of lien clause' that protects you if your contractor doesn't pay for materials or labor. This means that you won't pay your contractor until he shows you written proof that he's paid his bills. The second protection is a 'financing clause' that says the contract is only valid if you can find a loan for your project. That way you won't be on the hook for a $20,000 remodeling job with no way to pay for it!

Home improvement projects can be both a source of joy and frustration. Navigating through the potential financial pitfalls will help avoid some of the most likely aggravations. After all, your home should be your castle. And a newly remodeled castle should definitely be something to be enjoyed!

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Gary Foreman

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money and Gary shares his philosophy of money here. You can follow Gary on Twitter or visit Gary Foreman on Google+. Gary is also available for audio, video or print interviews. For more info see his media page.

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