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Ask Dr. Don

Home equity vs. cash-out refinancing

Hello Dr. Don!
I would like to know the differences between home equity loans and debt-consolidation loans.

I have a 30-year fixed rate mortgage at 7 percent on an original loan amount of $75,000 and have paid on it for eight years. By paying a little extra each month, I've reduced the loan balance to about $62,000.

I just renovated my kitchen for about $14,000, and I was considering applying for a home equity loan to pay it off. Now our daughter is engaged and plans to marry in May 2003. We would definitely have to finance the wedding.

With an impending debt of around $24,000, could you offer any suggestions regarding home equity loans vs. cash-out refinancing vs. debt consolidation? With my new home renovations, my home could certainly be appraised in the low 90s. Any suggestion where I could start, PLEASE?
Patty Pantry

Dear Patty,
I'm assuming that you mean that you expect the wedding to cost around $10,000, and combined with the home repairs, you want to borrow an additional $24,000.

Any loan backed by real property is considered a mortgage. Home equity loans are another name for a second mortgage.

Debt-consolidation loans don't have to be mortgage loans, but homeowners who can tap the equity in their home will often wind up with a lower interest rate and may be able to deduct the interest expense on their taxes. If you're currently able to use the home mortgage interest deduction on your taxes, you should be able to use it after refinancing. When in doubt, check with your tax adviser.

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One thing that you want to avoid is paying private mortgage insurance (PMI) on a new first mortgage. If the first mortgage's loan-to-value will be more than 80 percent of the home's appraised value, the mortgage lender will require that you purchase a PMI policy. At an appraised value of $92,000, that means you would avoid PMI by getting a first mortgage for less than $73,600.

Your best solution is likely to be a home equity line of credit (HELOC) to go with your existing mortgage. Your current mortgage is at a competitive rate, and you're not likely to realize much, if any, savings from refinancing the $62,000 balance. With a line of credit, you can borrow what you need when you need it and pay it down over the loan term.

That way you don't have to borrow for your daughter's wedding today and wind up paying interest on that money over the next year and a half. Plan on some overlap, and get a HELOC large enough to cover both the remodeling and the wedding, but work on paying down as much as you can on the line of credit used to finance the remodeling costs between now and the wedding.

Another good thing about HELOCs right now is that they are priced on short-term interest rates. With the Federal Reserve's aggressive moves in lowering the Fed Funds rate over the past year, these short-term rates are very low. This won't last forever, and the interest rate on a HELOC will re-price with changes in the short-term interest rate that it is indexed to, but more of your monthly payment can go toward the repayment of principal with these low rates.

At this writing, the average $30,000 HELOC carries a rate of 4.74 percent. You can find today's average rate on Bankrate's Home Equity page.

You're going to pay closing costs no matter what you do, but closing costs on a HELOC should be lower than the closing costs on refinancing your mortgage.

What you need to be careful about with a HELOC is that the minimum payments won't be enough to pay off the loan over its term. If you don't make monthly payments for more than the minimum, you'll wind up with a large balloon payment at the end of the loan term.

The easiest solution to this is to use Bankrate's mortgage calculator to determine how much you need to pay each month to pay off the loan over it's term. If you borrow more, or when the interest rate changes, you can go back to the calculator to determine the new payment.

-- Posted: Jan. 11, 2002

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See Also
Understanding cash-out refinancing
FAQ about trading equity for cash
Mortgage checkup: Inspect your mortgage and save money


Home Equity
Compare today's rates
$30K HELOC 4.74%
$50K HELOC 4.53%
$30K Home equity loan 5.37%
Rates may include points

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