How Much Can I Borrow?
If you will require a loan to pay the cost of your remodeling project, you may have several options to choose from. However, a limiting factor is how much you can borrow. Determining your available credit is an important first step in planning your project.
When applying for a loan, you will probably be required to specify how much you want to borrow, or if you apply for a line of credit, what credit limit you seek. Therefore, you need to have an idea of what your project costs will be. You don't have to have firm bid to get started, but you do need a good idea. The problem with getting a firm bid is that you will need plans drawn, at least for a large project. However, it may be a waste of money to have plans drawn up if you can't afford the project in the first place.
Getting an Estimate
Determining the cost of the project is not an exact science. There are so many variables, that determining the exact cost is usually impossible. However, it is possible to get a good general idea. There are books on the market, that break down the cost of various work, adjusted for regional differences. The problem is that these books require you to know which work will be required. There are cost estimators on the web, that give a very rough idea of cost, but they do not take everything into consideration. If the estimator does not adjust for regional variances, usually by asking for your zip code, then the cost may be grossly inaccurate. Another option is to start interviewing contractors now, and when you meet with them, ask them to provide a rough non-estimate based upon your project description.
In addition to estimate, you should add a contingency figure, to allow for the unexpected. Ten percent is a commonly suggested figure. If you will move out during construction, add on the cost paying rent (remember, your mortgage payment will still have to be paid). Your estimate may not include the costs of permits, fees, engineering costs, architectural design costs, printing of blueprints, and a myriad of other expenses that can add up. Finally, an additional cushion should be available, just in case. This extra cushion may be need to be as much as 30%. Running out of money before the project is not a position anyone wants to be in.
Lenders consider a lot of things when evaluating your loan application. But if you are putting your home up as security, one thing they all look at is you loan-to-value (LTV) ratio. Bottom line, your lender wants to know that no matter what, they will get their money back. That means in a worse scenario, they will have to foreclose on your home and sell it to get their money back. They want to be sure they can sell it, pay off any senior mortgages and have enough left to cover their loan and accrued interest.
To calculate your LTV ratio, start by adding together the balance of all your mortgages on your home, plus the amount you want to borrow. Now divide this figure by the estimated value of your home. For example, let's assume a 1st mortgage balance or $150,000, a 2nd mortgage of $25,000 and you will need $50,000 for your remodel project. Add these figures together for a total of $225,000. If your home is worth $450,000, then divide $225,000 by $450,000, which results in a 50% LTV ratio. This means that half the value of your home is encumbered by mortgage debt and the rest will serve as a cushion to protect the lender.
Most lenders like a LTV ratio of 70% or lower, although a few will lend up to a LTV ratio of 100%. To calculate the maximum amount you can borrow, multiply the value of your home by the maximum LTV ratio your lender offers and then deduct all existing mortgages. The remaining figure is the maximum loan amount. Using the example above, $450,000 x 70% = $315,000 - $150,000 - $25,000 = $140,000 maximum loan amount.
Your Ability to Repay the Loan
Your lender wants to know that you will be willing and able to repay your loan. The two most important factors they consider are your credit score, which demonstrates your past history of bill payment, and your income, which proves you will be able to afford your new payment.
Your credit score will have a direct affect on the interest rate and fees you pay and thus on how much the payment will be and ultimately how much you can afford to borrow.
Your income versus your expenses is referred to as your debt ratio. Add together all of your payments, mortgage, credit card, car loan etc. and divide that by your gross monthly income. That figure is your debt ratio and lenders like that to be no higher than 36%. If your new payment will put you over that threshold, you may still be eligible for a loan, but the interest rates and fees are likely to be higher.
Your loan costs are the interest rate you will pay and any fees or points that will be charged. The higher the rate and fees, the less loan you can afford. Therefore, you may want to choose a loan type that offers a low initial interest rate. You will be able to qualify for more, and during the initial term of the loan, you will have lower payments. Later, the interest rate and payments will increase, presumably as your income and thus your ability to afford them increases.
Longer loan terms stretch out how long you have to repay the loan and reduce the monthly payments. However, you pay substantially more in interest on a longer term long. To lower you payments, choose a longer term. To lower the amount of interest you pay, choose a shorter term. In some cases, shorter term loans also come with slightly lower interest rates, an additional incentive to take a shorter term loan.