Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Cash-out refinancing vs. home equity loans

Dear Dr. Don,
Can you get money out of refinancing your home to use for major home repairs? Or should you just get a home equity loan? There is only about a 1 to 1.5 percent difference in the two loan rates.
Brian Between

Dear Brian,
Try to achieve your financial goal, which is major home repairs, at the lowest expense that still fits your budget.

Refinancing your home should give you a lower interest rate on the overall debt, but the closing costs on a refinancing are typically higher than those associated with a home equity loan.

Whether it makes more sense to refinance and take cash out or borrow using a home equity loan depends on your financial goals, the interest rates on the new loans, the interest rate on your existing mortgage, your marginal income tax rate and your ability to use the mortgage interest deduction on your income taxes.

A good method for deciding is to look at the "weighted APRs" of the loan alternatives. "Weighting" the APRs is easy: You take the interest rate of each loan and multiply it by its portion of the total debt. Let's say a homeowner owes $100,000 on an existing mortgage and wants to spend $50,000 on renovations. If the homeowner takes out a $50,000 home equity loan or line of credit, the homeowner would owe a total of $150,000: two-thirds of it in the form of the original $100,000 mortgage, one-third of it from the new home equity debt. So to get the weighted APRs, you would multiply the rate of the $100,000 mortgage by two-thirds and the $50,000 equity loan by one-third (see table below for example).

Choose the alternative that has the lowest weighted APR with payments that fit your budget. Because APRs include estimates of closing costs, this method adjusts for the differences in closing costs among the alternatives.

Substitute your own values into this table to help you decide which type of loan is right for you. Use the Bankrate loan calculator to determine the payments when constructing your worksheet.

In my example, a cash-out refinancing gives you a lower monthly payment, but higher overall payments since the homeowner would be paying for 30 years. If the homeowner makes an additional principal payment of $250 each month on the refinancing alternative, the entire loan will be paid off in 2018 with total payments of $258,534.

Home equity loans are paid off over a shorter period than mortgages, which increases the monthly mortgage payments. Since you can make additional principal payments on the refinancing to bring down the loan balance, the shorter term of the home equity loan isn't an advantage.

A home equity line of credit (HELOC) is revolving credit, so you can pay off the home repairs and borrow against the line again without having to take out another loan. Since the interest on personal loans isn't tax deductible and the interest expense on a mortgage or home equity loan typically is tax deductible you can save money by using the revolving credit line.

A HELOC is a variable-rate loan, and minimum monthly payments won't amortize the loan. You have to have the financial discipline to make monthly payments that will pay off the loan over its term. Otherwise, you end up with a rather nasty balloon payment due at the end of the loan.

The payment presented for the HELOC alternative in the table is based on the rather unrealistic assumption that the interest rate never changes, but it will pay off the loan over its 15-year life.

Finally, if you can use the interest-expense deduction on the home equity loans, you should be able to use the deduction on the cash-out refinancing. This IRS flowchart will help you determine if you can use this deduction. IRS Publication 936 has the complete information on home mortgage interest deductions.

-- Posted: Aug. 22, 2001