You're confused. You've decided to add on a master bedroom suite and expand your garage. The lender says it would be best financially to use an equity line of credit to make the improvements and refinance later. But wouldn't you be duplicating your borrowing costs?

Perhaps not. Depending on the costs to set up the equity line as well as the projected costs to refinance, this approach may very well make economic sense.

Here's why.

Let's say you need approximately $70,000 to make the improvements. You currently owe $55,000 on your mortgage, and the property should be worth approximately $150,000 when the remodeling is complete. By funding the improvements using a low introductory interest rate on the equity line, it allows you to not only pay less interest initially, but requires that you make payments only on the outstanding balance.

For example, if the contractor bills you $15,000 for improvements the first month, the equity line payments would be based only on that balance. Unlike a traditional second mortgage where you receive loan proceeds for the entire amount at closing and repay in equal payments, a line of credit gives you the flexibility to borrow only what you need, when you need it.

If you initially obtained funds by refinancing into one new, larger loan, what you could borrow could be based on the property's current value, not the improved value. That could mean you'd be short of the total funds needed. Even if you were to obtain all you needed by refinancing, your payments would be higher than the equity line since you'd be borrowing more, probably at a higher interest rate. And with the anticipated amount you'll need for improvements (plus being able to pay off your current loan of $55,000) the refinanced loan could require private mortgage insurance since you'd need a loan that exceeded 80% of the property's value. This, too, would increase your monthly payment.

Before you make a decision, be sure to ask what the lender will charge to originate the equity line, as well as the total estimated costs to refinance once improvements are complete. If those costs don't exceed the savings you'd realize by the lower interest rate and lesser payments on the equity line, then it would pay to structure the loans as suggested.

It would also be wise to obtain a firm commitment on the future refinance barring anything changing in your financial picture. One of the down sides of most equity lines is that it must be paid off when the property is sold, usually won't allow other loans to be placed with it, and the low introductory rate of interest will typically expire in one year or less. Once the low interest rate expires, the new rate is often based on the prime rate plus two percent. If you later found you couldn't qualify for a refinance, you'd be saddled with higher payments on a large balance, realizing more not less costs by taking the equity line of credit route.

As is always recommended, obtaining financing counsel initially from more than one lender can give you the best idea of options and related costs.

Published: August 14, 2000

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Julie Garton-Good, DREI “The Frugal HomeOwner™” As a syndicated newspaper columnist, author and international speaker, Julie Garton-Good DREI, C-CREC™, is called “America’s Home Affordability Expert”, addressing more than 25,000 persons annually on topics of real estate industry trends and home affordability. She is the author of five real estate books and is the sole two-time recipient of the international "Real Estate Educator of the Year" award from the Real Estate Educators Association. In 1997, The National Association of Realtors® nominated Julie as one of the fifty most influential people in the real estate industry. She shared the list with only three other women.