||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
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
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
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
The easiest solution to this is to use Bankrate's
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