Beware the true cost of renovations
NOT ALL PROJECTs will increase the value of your home, so make sure to budget wisely
Renovations can be a good investment, if they increase the value of your home. But sometimes, that big project may not be as financially rewarding as you hope.
I recently sat down with Jenny (not her real name), who had spent more than $100,000 renovating her home. Now she’s worried about how those renovations will affect her finances and her ability to retire.
In 2006, Jenny decided putting money into her house was the best investment she could make, given that her mutual funds weren’t doing so well. She began with a kitchen renovation that was over-budget from the start. She ended up with a beautiful kitchen, but $30,000 less in savings.
Soon enough, Jenny noticed the living room and dining room carpet looked old next to the kitchen’s new tile. She decided to put in new hardwood flooring, paint the walls, replace the old windows, change the light fixtures, redo the fireplace and add a new built-in wall unit around the fireplace for her new big screen TV. This would cost a further $50,000. Instead of using the rest of her savings, she decided she would put this on her line of credit, which would cost her $208.33 per month.
If she was already paying that much per month, she figured she might as well also renovate two bathrooms, the master bedroom, and replace the rest of the windows in the house, for a total cost of $72,000 or $300 per month.
Don’t forget principal and interest
Jenny’s first mistake is that she focused too much on the payment, which was interest only as opposed to the actual debt or the total cost of interest. If she amortized the $72,000 debt over five years, her payments would be $1,358.73 per month instead of $300 per month. Over that five-year amortization, the loan would cost $9,523.73 in interest giving the $72,000 renovation a real price tag of $81,523.73.
The bigger problem is Jenny did not budget for $1,360 per month in payments. Instead, she thought she would just make the interest-only payments and would tackle the principal from time to time, when she had extra money. Five years later, Jenny still had $58,000 left on the line of credit. Over the past five years, I estimated that Jenny had paid about $15,000 in interest instead of the $9,523.73 she would have had, if she had made regular payments over the five years.
This renovation proved to be very expensive once we factored all the interest she has paid and is going to pay.
To make matters worse, Jenny wants to retire in three years, but the line of credit probably won’t be paid off by then. To pay it off in time, Jenny would need to make payments of $1,738.31 per month, which is just not realistic for her income. At payments of $1,000 per month, she will have the debt paid off in five-and-a-half years. Given her income will drop in retirement, she is not sure if she should work longer, get a part-time job in retirement or sell the house and buy something less expensive.
Renovations are a significant reason why many people have balances on their lines of credit. No one saves before they renovate anymore. They renovate and then pay it off.
In an essay, French philosopher Denis Diderot, he described receiving a beautiful velvet robe as a gift. He loved it, but noticed that it made his other furniture look old and shabby. So, piece by piece, he replaced his furnishings with new ones that matched the robe’s richness.
Because one renovation can often lead to another, renovations have become big business. In Jenny’s case, replacing the kitchen counters led to a complete kitchen renovation, which eventually led to a transformation of the living room, dining room, bathrooms and bedrooms, not to mention the new couch and dining table she bought to match the new decor.
Renovations can be very rewarding — even financially so — but before you renovate, make sure you have a budget. And, if you are going to go into debt to finance the renovations, make sure you have a plan for paying off the debts.
If you are nearing retirement, make sure you understand the impact of debt on your ability to retire and how it might affect retirement cash flow.
Remember, too, that not all renovations will increase the value of your home. I see too many people justifying renovations based on how much they will increase the value of their home, only to discover their assumptions were incorrect.