Qualifying for a Home Renovation Loan: How Much & Why?

Learn how lenders determine how much of a home renovation loan you can borrow to improve and renovate your home. Very detailed and informative.
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Contemporary home fully renovated

How do lenders calculate how much you can borrow for home improvement projects?

Financing a home renovation can be a painstaking endeavor for some. It’s understandable to be confused, what with all of the financial jargon being thrown around; LTV, debt-to-income ratio, and points. What does this all mean?

Obviously, when large sums of money are involved, it’s always in your best interest to be informed.

Those that don’t do their due diligence are unlikely to come out of the situation unscathed. By understanding exactly what you need to receive the loan that best fits your specific situation, you can take control of your financial situation every step of the way.

  • What do lenders look for when qualifying a loan?
  • What actions can you take to lower your interest rate and avoid paying an arm and a leg?
  • Where do you even start?

This article delves deep into the vital information that you’ll be required to know before you ever step foot inside the office of a lender.

TABLE OF CONTENTS

Calculating How Much You Need to Borrow
How do Lenders Calculate How Much You Can Borrow?
Loan-to-Value Ratio
Why Do Lenders Look at Income?
How Your Credit Rating Affects Your Loan
All About Interest Rates
The Loan Term
Definitive Guide to Loan Improvement Loans
How to Pay for Home Renos without Piling on Debt?

Calculating How Much You Need to Borrow

It’s essential that you are able to compile an accurate estimate of the total costs involved in your renovation process. For the most part, lenders (see home renovation loan options here) will not work with people unless they have specific figures.

This means that as the home owner, it is up to you calculate the total projected price of your renovation. If you choose to employ a contractor, start with a firm bid that entails the coverage of costs for both materials and labor and then add 10% more, just in case of surprises.

If you choose to go about renovating your home by yourself, then it may be advantageous to create a spreadsheet that contains a detailed list of material quantities, cost, and an accurate total. Don’t forget to include any potential permit fees or equipment rentals that may also be necessary as well.

Unlike professional contractors that generally have their figures dialed in, the average person that doesn’t renovate homes for a living may come across additional costs that were not originally thought of. That is why it’s usually advised to add as much as 20-30% more to the estimate to act as a buffer to cover the cost of any unforeseen circumstances that may arise.

Once you’ve devised how much you’ll need, it’s time to find out how much you’ll actually receive.

Often time’s lenders use commercials and other forms of media to advertise their services. These ads may promise set amounts, but realistically, the size of the loan you receive depends on numerous qualifying factors. Unfortunately, the prices they quote are not always congruent with what you’ll actually qualify for, so it’s important to take what you’ve seen on TV or read online with a grain of salt until you’ve actually spoken with a certified lender.

Your income, credit rating, and loan-to-value ratio will be scrutinized under the careful eye of a lender to determine not only how much you can borrow, but also whether or not you’ll be required to pay points, the overall length of the loan, and the interest rate. Needless to say, these factors are rather important in shaping the way you borrow money.

It’s important to understand that lenders are in the business of making money, not losing it, so at times, they can be quite prudent when qualifying loans. It is their objective to provide the highest quality loans for the smallest margin of risk. This is how they weed out poor candidates and ensure that they receive their payments in full.

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How do Lenders Calculate How Much You Can Borrow?

So, before we continue, I’d like to explain each one of these critical factors individually, so that you gain a deep understanding of what mitigating factors can help (or hurt) your chances of receiving the funds that you need.

Loan-To-Value Ratio (LTV) Explained

The LTV ratio is a comparison between the value of your home and the value of the loan you are attempting to qualify for. This is a method lenders use to determine how much equity you have in a property.

Believe it or not, your LTV is actually quite easy to calculate; it is simply your loan amount divided by the low end appraisal price of your home.

For example, let’s assume that you purchase a home for $200,000 the loan that you’d like to qualify for is $20,000, then your LTV is 10% (because your loan would be equivalent to 10% of the value of your home).

Here it is: $20,000 / $200,000 = .1 (or 10%)

The LTV is calculated for every loan, regardless of what its intended purpose is. The higher the loan to value ratio, the higher the risk is for the lender. Let’s say that your loan had an LTV of 100% (meaning that the requested loan amount is equivalent to the amount of equity you own), and for some reason, you failed to make your payments.

The lender would then foreclose on your home to recoup the price of the money that is owed. However, if the LTV exceeded 100% and was 120% for example, then foreclosing (or selling) your home would cause the lender to lose money because the amount owed for the loan exceeds the worth of the home.

Obviously, for a home improvement loan, the likelihood of having an LTV of 100% is relatively slim, but I believe it’s important to understand exactly what a loan-to-value ratio is and how it’s calculated, because it is a determining factor in how much you will be allowed to borrow.

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Why Do Lenders Look At Your Income?

When applying for a loan, lenders aren’t simply looking at the total amount that your household brings in, but also take into account the amount of expenses that you may have accrued. Having a high income is no guarantee for a larger loan.

Lenders generally follow two rules of thumb when minimizing their risk;

Lender Rule #1 – Your house payment, including principal, insurance, taxes, and interest should not exceed 25-28% of your gross monthly income. The highest debt-to-income ratio is 42% on second mortgages. However, some lenders will opt to go even higher at the expense of increased fees, rates, and monthly payments.

In order to maximize your ability to receive the loan that you’re after, without having to shell out additional money for monthly payments, it’s generally advised to maintain a debt-to-income ratio of 38%.

Lender Rule #2 – Your debt and home payments should be 35% or below of your monthly income.

Your loan to value ratio will be the determining factor in how much you will be allowed to borrow, while the debt-to-income ratio indicates what your monthly payments will be.

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How Can Your Credit Rating Affect Your Loan?

A credit rating is surmised as an evaluation for the financial “worthiness” and reliability of the debtor and is defined by a letter rating. The best rates and terms allowable will be given to those that have proven themselves to be distinguished “A” rating.

Only those with no late payments in the last 12 months or no maxed out credit cards will be eligible for this status. However, if you have less than stellar credit, it doesn’t necessarily mean that you won’t qualify for a loan. It just means that you may end up with a smaller loan or a higher interest rate.

What Are Points?

Points are a form of pre-paid interest. Each point is equal to one percent of your loan amount. When charging a borrower points, the lender succeeds in increasing the yield of the loan above the cost of the interest rate.

Borrowers often offer to pay points in order to effectively reduce the interest, allowing the borrower to pay less monthly. For each point purchased, the loan rate is typically reduced by 1/8% (0.125%).

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All About Interest Rates

Unfortunately, nothing in life comes free (including home improvement loans). For the privilege of receiving money, a lender will charge you additional money. This is how lenders make their money.

If we simply paid the amount back for the money we received, without an additional rate, then they would simply be handing out money for free and there would be nothing to gain for the lender.

For instance, if a lender decides to give someone a loan for $100,000 that will be paid off over the course of 5 years, and an agreed upon 2% interest, then by the end of 5 years time, that person would have paid off the $100,000 plus an additional $2,000. In this particular instance, the lender earned $2,000 for allowing that person to take out a sizable loan.

The lower the given interest rate, the larger the amount you will be able to borrow. Once an interest rate is given, it does not have to be set in stone. One method to temporarily reduce the rate of interest is to use an adjustable rate mortgage (ARM).

An adjustable rate mortgage offers an introductory interest rate that lasts a set period of time before it begins to adjust annually for the remaining time period of 30 years [1]. The initial interest rate for an ARM is normally lower than a fixed rate, which in turn, means that your monthly payment will be lower.

However, there is a downside using an ARM, as the interest rate will begin to increase after the initial fixed period.

For those that plan on selling their home shortly or have preconceived knowledge that their income will increase by the time the fixed period ends, then an ARM is an excellent choice for borrows. For those that plan to live in their home for many years to come and are not expecting a considerable increase of their income, then an ARM may be a bit risky.

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The Loan Term

The longer the payback period for the loan, the lower the monthly payments will be. However, the longer the loan term, the higher the interest will be.

Lenders don’t want to wait 30 years to receive their money, so they will reward borrowers that choose to pay back their loans in a shorter duration by allowing for a lowered interest rate.

Shorter loan terms are advantageous because you will pay less overall, as long as you can handle the increased monthly payments.

What’s Next?

Obviously, this is only the first step, albeit a crucial step, to receiving the loan that you require. However, having a solid grasp of the basics will allow you to make the choices that are in your best interest when it does come time to choose a loan.

Many people aren’t as fortunate and blindly walk into a financial situation that is less than desirable for their specific circumstances. By understanding what criteria lenders use to qualify applicants, you will now have the power to control the outcome.

References:

[1]  The Federal Reserve Board.  Consumer Handbook on Adjustable-Rate Mortgages.

(c) 2015









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