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

Using a home equity loan to pay off a mortgage

Dear Dr. Don,
If my current mortgage payoff is equal to only 29 percent of the market value of my home, can I use a home equity loan to pay off my mortgage?  I want to get around some of the bogus closing costs that many mortgagees are charging for refinancing, i.e. another title search, processing fees, uncle George's root canal, the new car payment, etc. 
Thanks.
Karla Knowing

Dear Karla,
You can use a home equity loan to pay off your mortgage, but it may not be your best decision. 

A home equity loan is a second mortgage.  As a second mortgage, its interest rate reflects the additional default risk.  That means that the first mortgagee gets its money before any claims are paid to the holder of the second mortgage.  When you use the proceeds of a second mortgage to pay off the first mortgage, the second mortgage is no longer a second, but it is still priced as if it was.

You're right in thinking that closing costs are typically lower with second mortgages than they are with first mortgages, but many of the same costs apply to both kinds of mortgages. 

Bankrate's survey of closing costs can help you determine what's normal and reasonable. Then use the FTC's Mortgage Shopping Worksheet to track closing costs for the different types of loans when talking to lenders.  You may be surprised and find that refinancing is actually the less-expensive option.

You'll also have to decide between a home equity loan and a home equity line of credit (HELOC.)  This Bankrate basic can help you choose between the two loans.

A home equity loan is typically a self-amortizing loan at a fixed rate of interest, meaning that the payments are high enough to cover the interest expense and repay the loan balance over the loan term, and the interest rate won't fluctuate. 

A HELOC has a variable interest rate, and the payments aren't self-amortizing.  If you only make the minimum payments you can find yourself owing a large balloon payment at the end of the HELOC's loan term and scrambling for new financing.

The table below shows a comparison between the three types of loans using Bankrate averages for the interest rates. 

One problem you may encounter when shopping for a loan is that your loan amount may be too small to qualify for some refinancing loan programs and too big for the typical home equity loan.  It's not an insurmountable problem; it just may require you to do more shopping than you had planned.

It's important to compare the loans over an equal loan term, so I've assumed a payment on the HELOC that is self-amortizing, and that the home equity loans are extended to 15 years to make them equal to the mortgage term. 

Use Bankrate's mortgage calculator and your estimates of closing costs to come up with your own table. Most homeowners would use the refinancing in this situation, even though at first blush it's more expensive than the HELOC.  The rate on the HELOC can bounce around a lot over the loan term and the certainty of a low fixed rate is appealing.

-- Posted: Dec. 3, 2001