Primer on financing home renovations: 2nd mortgage or cash out?

[Chris Mason]

This is intended to be a tool in your toolbelt. Combine this with all of the other great approaches to real estate here on Bigger Pockets.

Just got off the phone with a homeowner in Oakland that was exploring two options to finance $14k in home improvements. 

1. $14k subordinate lien @ 8%.
2. Cash out refinance to pay for the $14k. Her current mortgage balance is $314k.

I told her to take the $14k @ 8%, and leave her existing mortgage in place.

Here is the math you do in order to determine the average finance charge per dollar of debt.

( [ rate1 * balance1 ] + [ rate2 * balance2 ] + [ rateN * balanceN ] ) / TotalOfAllBalances

In her case, she proudly declared to me that she is sitting pretty at 3.625%. Her mortgage statement revealed that it was an FHA mortgage with FHA MIP @ .85%. So her total effective finance charges for the balance of the mortgage is actually [ 3.625% + 0.85% = 4.475% ].

Now that we know her actual interest rate, we can plug it into our formula.

( [ 4.475% * $314k ] + [ 8% * $14k ] ) / $328k = 4.625%.

So, 4.625% is the target to beat. In her scenario, that would have required her home to appraise for about $415k. If it didn't appraise for that, we'd end up with PMI of some form and would not hit our target number of 4.625% or less (including PMI). She told me that homes near her that are similar to hers sell for about $350k. Meaning that even if we shoved into one of the energy efficiency programs out there that go for higher LTVs, we'd still be stuck with PMI, it wouldn't make sense, and it would have taken an appraisal fee and a bunch of hassle on her part to arrive at that conclusion.

So, I told her to take the $14k @ 8%.