By FPA member Eric S. Toya, CFP®
Last Updated: April 2, 2012
For decades, American homes have steadily increased in size. The average square footage of a new single family house ballooned from an average of 1,660 in 1973 to 2,521 by 2007. Since the peak in 2007 (not coincidentally, also the peak of the real estate bubble in many parts of the country), the average new home size declined to 2,392 in 2010.1 In fact, a recent survey by the National Association of Home Builders, in which they surveyed over 3,000 builders, designers, architects and manufacturers, indicates that this trend is expected to continue, predicting the size of new single family houses to be 2,152 square feet in the year 2015.2
The trend clearly shows that Americans are coming around to the idea that bigger is not necessarily better and perhaps less is, in fact, more. Houses are now being designed not to wow guests, but to welcome them. Instead of moving out and up, more Americans are looking to stay in their homes and improve the space around them. But when it comes to home improvement, financing the home improvement project of your dreams could be your biggest challenge.
Consider your options:
- Pay as you go: Probably the most prudent of options, pay cash for your home improvement project rather than taking on debt. Of course, if you don’t have the funds available, this may mean saving up for your big project over a period of months or even years. This may provide you with time to plan your project, line up contractors and even learn to do some parts of it yourself.
- Home equity line of credit: If you are going to borrow against the house, a line of credit gives you the most flexibility. This will usually be the lowest rates that you can get, and the interest will generally be tax deductible. Limits to tax deductibility apply both in terms of the size of the loan and the ratio of the loan to the value of the house.
- Home improvement loan: If you are gong to borrow more than the value of your house (which is generally not recommended), then this is the way to go. If you take out a home equity loan and the amount of that loan plus your first mortgage is greater than the value of your house, then you are limited in how much of the interest you can deduct. However, if the second mortgage is used to substantially improve the residence, then it is what is called "acquisition indebtedness" and is essentially treated the same as the first mortgage for tax purposes.
- Don’t get saddled with too much debt: Before you embark on color schemes and designs, sit down and do your budget. Not the budget for the project, which of course is always more than you think it will be, but your household budget. How much do you make and where is it going? You should not be spending more than 30 percent of your gross income on housing. That's not just your mortgage but your property taxes, HOA fees, any upkeep.
- Consider hidden costs to your project: If it's a really big project, there's a good chance it will increase your property taxes. If you are planning to increase your square footage, will it cost more to heat and light the space? Will you housekeeper charge more to clean the larger space?
- Remember why you are doing this; tune in to the home improvement shows or magazines and they will often tell you that certain projects increase your resale value more than others. However, remember that most home improvement projects will not increase the value of your house by more than the cost of the project. Consider this article in Remodeling Magazine which indicates that most projects increase your resale value by not more than two thirds of the cost.3 Be realistic with yourself and the scope of your project.
FPA member Eric S. Toya, CFP®, is Vice President of Wealth Management for Trovena, LLC in Redondo Beach, Calif. Eric graduated from the University of Southern California with a BS in Finance and Accounting. Eric has been quoted in national publications, including The Wall Street Journal, Money Magazine and the Los Angeles Times.