Building inspectors can uncover problems that should be addressed in remodeling and also monitor compliance with building codes during construction.
What to Expect in Today’s Home Loan Market
Everybody knows that credit is tighter than it’s been in a long time and the reasons behind it. In the aftermath of a long period of rapidly escalating values for homes purchased on lax credit terms, the bubble has burst, and defaults on home mortgages have reached record numbers. Foreclosures continue to escalate, home values are down, and banks have grown wary—not in the least because their aggressive lending practices are widely blamed for the misery.
While many say the housing market has bottomed out and may have stabilized, neither home values nor credit availability are likely to improve dramatically for years. None of this means that you can’t get a loan to remodel your home, but you may have to analyze your credit worthiness more closely and work a little harder to qualify.
Eligibility for a home loan is based on a number of factors:
- Your overall credit score
- The loan-to-value ratio for your home
- Your total-debt-to-income ratio
You should easily be able to obtain a home loan if your credit score is 640 or better, if the loan-to-value ratio for your home is lower than 95 percent and if your income-to-debt ratio is 36 percent or lower. If any of the numbers in your case do not meet these thresholds, you may be able to improve the picture before applying for a loan.
Your Credit Score
A credit score is usually based on information collected by three major American credit bureaus: Equifax, Experian, and TransUnion. One of a number of statistical analytic methods is applied to the information on behalf of a lender to derive a credit score. The most familiar analytic model is known as the FICO score, but any given lender may use others, including NextGen, VantageScore and the CE score, to characterize an individual’s credit worthiness. It is important to note that each of the credit bureaus may have slightly different information about you, and the various analytic models weight the data differently in making their calculations.
While the exact formulas are secret, the FICO formula weights the following factors in roughly this way:
- Payment history—35%
- Credit utilization—30%
- Length of credit history—15%
- Types of credits used—10%
- Recent credit inquiries—10%
A history of late payments on mortgage loans, car payments and auto loans can cause your credit score to drop. Establishing a record of no late payments within the prior six or seven months should help to raise your score.
Credit utilization measures the ratio of revolving (credit card) debt to the amount of credit available to you. You can improve your credit score by paying down balances, but you’ll hurt your score if you pay off credit card balances and close the account. You’ll look best if you have a lot of revolving credit available but don’t use it.
A long history of using credit cards and making installment payments for cars and the like enhances your credit score, assuming the record shows that you pay your bills on time. If your history shows many recent credit checks and/or large amounts in charge card credit recently obtained, it will hurt your credit score. Shopping for a mortgage and car loans should not lower a credit score.
As noted, each of the credit bureaus may have different information about an individual’s credit history, and that information is not always up to date. The first thing to try if you need to improve your score is to identify mistakes in the information the databases are carrying. If you’ve paid off a large debt that’s still in their records, let them know. If your credit accounts are carrying erroneous or disputed charges, let the credit bureau know. In addition to correcting mistakes in the record, you can improve your credit score by paying down credit card balances and maintaining on-time payments. Don’t seek additional revolving credit for six months prior to applying for a mortgage or home-improvement loan.
The Loan-to-Value Ratio of Your Home
Loan-to-value (LTV) refers to the percentage obtained by dividing the amount you owe on the mortgage by the home's value. For example, if your mortgage balance were $80,000 on a $100,000 home, your loan-to-value ratio would be 80 percent.
Different lenders have different thresholds for a maximum LTV. If you’re applying for a second mortgage to finance remodeling, the bank may want to use the cumulative or combined loan-to-value ratio (CLTV), which refers the total amount owed. For instance, if you have a first mortgage for 80 percent of the home's value and are applying for a second mortgage for 15 percent of the home's value, the CLTV would be 95 percent. In this scenario, your equity is 5 percent of the home's value, which should be enough to enable you to qualify for the loan if your credit rating is good.
If you intend to seek a loan for remodeling that would put your LTV ratio over the current value of your home, you will have to make a case that the project will increase your home’s value over and above the total that you’ll owe if the loan is granted. The way to make that argument to a lender is to use comparable sales in your neighborhood. For example, if your three-bedroom, two-and-half bath home is currently worth $250,000, and you’re planning to borrow $50,000 to add a new master suite, you’d do well to find a recent record of a local sale of a four-bedroom, three-bath house at at least $300,000.
It is important to note that the kinds of remodeling projects that add market value are generally additions of living space—bedrooms and bathrooms, for example—rather than luxurious amenities like gourmet kitchens and high-priced decorative fixtures.(see Cost vs. Value in Remodeling Projects). In a market where home prices in most places will probably trend downward for the foreseeable future, lenders will discount increased value claims to some extent to be certain that LTV remains comfortable.
Total Debt-to-Income Ratio
When you apply for mortgage refinancing or a home-improvement loan, the lender will assess your ability to repay what you’re asking to borrow by calculating two additional ratios: 1) Your mortgage payment divided by your monthly income, or housing payment ratio, and 2) your total debt expense—which includes all of your monthly obligations, including mortgage, car, insurance, and utilities—divided by your monthly income. To qualify for a loan from most sources, your housing payment ratio may not exceed 30 percent, and your total debt-to-income ratio must be less than 36 percent.
The Bottom Line
Inability to meet all or any one of the standards guiding today’s credit market doesn’t mean that you won’t be able to get a remodeling loan, but it does mean that you’ll probably have to borrow at higher interest rates. It’s also worthwhile to consider that if your financial situation makes you seem like a less-than-ideal credit risk to a lender, you should probably get your financial house in order before borrowing to remodel the one you’re living in.
The most reasonable home loans these days are financed through the Federal Home Administration (FHA) and Veteran’s Administration (VA) mortgage programs. Start shopping for a home-improvement loan among FHA- and VA-approved lenders.
