This is a guest post from JerichoHill.

Recently my fiancée and I have engaged in a bit of home-renovation. Several years ago, Julie bought half of a duplex in a suburb of Washington, D.C. It is rather small for a house today, with two bedrooms, one bathroom, and a finished basement. The bedrooms were small because the duplex was constructed in the early 1960s. Her place was large enough for a spoiled-rotten dog and the occasional stop-over from the best-fiancé-ever but wasn’t going to be large enough for the two (WOOF!) three of us, let alone a family.

I’ve been blogging about the home renovation process in the Get Rich Slowly forums, and J.D. asked for me to write a few posts on what we’ve done and what we’ve learned from our home renovation. Over the next few Saturdays, I’ll be discussing three components of the project: Costs, Capitalization, and Construction.

Because of the size of our house, Julie and I wanted to build out as large of an addition as we could. Our goal was to build an addition out-the-back flush with the property line and party wall for the basement and both floors. The addition space would house on the first floor our new kitchen, a new master bedroom on the second floor, and a den/bedroom in the basement. We also had several renovation wants for the existing structure. Would we be able to afford our wishes?

We first had to check with the city’s planning board to ensure we had the necessary permits and, if necessary, special exemptions or variances from the city. A well-thought out presentation which is quick and to the point stands a good change of winning over your planning board. We watched several petitioners in front of us engage in convoluted debate with the planners and not get approved. We were approved easily because we had researched the codes, had a case for why we needed what we were requesting, and presented our needs quickly and coherently.

There are several financing options available for a home improvement project:

  • You can self-finance,
  • You can refinance your existing mortgage,
  • You can take out a home equity line of credit, or
  • You can take out a home equity loan.

In our case, home prices had skyrocketed since Julie bought the house, so we had a large sum of “equity” to tap. Equity is essentially the difference between what your house is appraised to be worth and your outstanding mortgage balances. I wouldn’t recommend using “equity” to finance consumable spending, but I’ve heard of folks using equity for credit card consolidation for lower rates (secured by your home). We felt the equity in our home was the strength we should build on for our project. Your situation may be different, and you should consider reading about all your options, and utilize your financial situation’s strengths when choosing your method of financing.

To learn about differing methods of financing a home addition, Bankrate has some excellent free guides. Here’s how I think the various financing options break down overall:

  Good For: Be Aware Of:
Home Equity Loan One-Time
Large Projects
Most are Variable Rates
Home Equity
Line of Credit
Ongoing Projects
Terms, Pay Scheds
Refinance To get lower
interest rates
Closing Costs,
Rate Change
Self-Finance Small Projects Your Checking Balance

I found in talking to potential lenders that they will typically write a home equity loan that brings your debt-to-value ratio to no higher than 80%. You can go higher, but it costs more in fees and in rates. We did not feel a need to go higher than an 80% DTV ratio and did not want to pay a premium or potentially put us in harm’s way if the market turns drastically. What we didn’t know was that the home-equity loan provider will purchase your second lien (unless they are in first or second position already), and that left us with a smaller budget than we had at first thought we had. But we made due, and it wasn’t an issue.

After we knew the probable size of our home equity loan and available cash-on-hand, we met with our contractor / architect to confirm plans and ensure that we had enough financing to cover expected costs and potential over-runs. Our contractor walked us through his estimated budget and worked with our figures to show us what we could expect.

An advantage we enjoyed was a significant amount of liquid savings that we were able to use up front to cover quite of bit of the cost ourselves, as if we paid a down payment on our addition. Our reserves also made up for the fact that we under-estimated how long it takes to secure a loan, finish plans, and get construction approval. Because we had some reserves, we were able to start initial construction as the paperwork finished. We paid up front for many expenses and left a portion of our cash-on-hand budget available for the end of the project if we needed it. Looking back, I didn’t feel comfortable starting without those important details taken care of, but our timetable and lack of experience didn’t give us much of a choice.

Of course, before signing any papers we wanted to make sure we could afford the additional mortgage payment. I’ll talk about how I did that and discuss dealing with lenders next Saturday. We’ll finish with some great tips on saving thousands on your home addition!

You can follow the whole home addition process, including pictures and summaries, in this GRS forum thread.