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For Extra Credit, Figure Out Best Finance Option

Cash Call: Keeping Costs From Going Through the Roof


Once you've got the plans, the builder and the desire to remodel, you need just one thing more: money.

Even a relatively minor remodel is going to cost thousands of dollars, and a major project can set you back hundreds of thousands. Unless you've got a vault full of cash, you're going to have to find a way to finance your job.

There are several ways to go. You can save, pay the remodeling cost from income as you go along, sell stocks or other investments, or borrow.

Though it's wise to save for some of the cost to help cover unexpected expenses during remodeling, saving enough to pay for the whole job, particularly a big one, is impractical. In many cases, it would take so long that your building permits would expire--and so might you. And unless your project is relatively small and your income is relatively large, paying as you go could turn your construction project into a lifetime endeavor.

Many people like the idea of selling other investments to finance a project because it saves them from having to pay interest. But it has a down side: taxes.

If you sell an investment at a profit, you must pay tax on the gain. The size of the tax hit will depend on how long you've held the investment, your tax bracket and the type of investment you sold. However, the federal tax cost typically runs between 20% and 40% of the profit.

The hit is even greater in California, which imposes a 9.3% top marginal tax on all types of income, on top of federal taxes. Ouch.

Naturally, any investments you sell aren't invested and earning money for you anymore, so you also miss out on any future appreciation. That's called an "opportunity cost."

If that sounds like a bigger expense than you anticipated, you may consider the other option: borrowing all or part of the cost. Again, there are several ways to go.

Here are a few of the better options:

* A home equity line of credit allows you to borrow up to a set percentage of the equity in your house. That percentage varies by lender, but often amounts to between 90% and 100% of the home's equity. The money can be used for any purpose, from remodeling to buying a new car. The interest paid on a home equity line of up to $100,000 is usually tax-deductible too, no matter how you use the loan proceeds.

For those with sufficient equity in their houses--equity is the difference between the home's market value and the balance on your loan--a home equity line can be a cost-effective choice because there are few upfront costs and the interest rates are generally low. For instance, aside from appraisal and title fees, most lenders will charge just a $50 to $75 loan origination fee.

You don't need to pay interest on the loan until you start to use the cash, which you usually do by writing a check against the account. (You usually get a checkbook automatically with a home equity line.) The interest rate will depend on your lender, your credit score and how much equity you'll still have in the home. But rates generally run within half a percentage point of the going prime rate, a bit below if you have exceptionally good credit and a bit above if you don't.

Aside from the low cost and tax deductibility, the main benefit of a home equity loan is that you have control over the cash. No one looks over your shoulder, telling you if you ought to write a check. You're on your own.

Of course, if you're not a sophisticated consumer of construction services, this can also be a detriment. That's simply because you might be able to use a little advice about whether your payments are getting ahead of the work, a savvy remodeler's no-no.

* Construction loans used to be costly and ponderous. Under the old model, you'd get a short-term construction loan and then have to refinance to a permanent loan when your project was complete. Naturally, you paid points and fees when you secured both the temporary and permanent financing, which made these loans costly and inconvenient, says Jim Fraser, senior vice president of construction lending at Indy Mac Bank in Pasadena.

But the market has changed dramatically in the last few years, partly as a result of a big secondary mortgage lender's getting into the business and pushing a standardized "one-step" loan, which folds both the construction costs and the permanent loan into one package, with one set of approvals and one set of closing costs. Today, construction loans are only incrementally more costly than home equity loans, Fraser adds.

However, there are two big differences between a construction loan and a home equity loan, and they can make construction loans very attractive to some borrowers. The first is how much money you can borrow.

With a construction loan, the lender doesn't look just at what your house is worth today when determining how much to lend. Instead, the appraiser looks at your remodeling plans and determines value based on what the house will be worth when the job is complete.

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