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Ask Dr. Don
Bankrate.com

Refinancing with a HELOC

Dear Dr. Don,
I have received an offer for a home equity loan. They want me to open a line of credit of $109,000 to pay off my existing mortgage. It is a variable-rate loan. Is this a wise thing to do?
Gary Gradation

Dear Gary,
A home equity loan is another term for a second mortgage. It's called a second mortgage because it's second in line to be paid off in foreclosure. When you use a second mortgage to repay your first mortgage, the second mortgage moves to the front of the line, reducing the lender's risk.

One potential problem in using a home equity loan to repay your current mortgage is that the loan isn't priced to reflect that fact.

There are two types of home equity loans, a standard home equity loan and a home equity line of credit (HELOC). There are important differences between these two types of loans.

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A HELOC is revolving credit with a variable interest rate. As you pay down your loan balance during the draw period, you can re-borrow the money up to the loan limit. The draw period typically lasts for the first 10 years of the loan.

The monthly payment during the draw period is usually just the interest expense on the outstanding balance. In contrast, the home equity loan has a fixed interest rate and the loan is amortized over its loan term so the monthly payment covers both principal and interest.

Home equity loans and HELOCs generally have lower closing costs than the costs associated with refinancing a new first mortgage. These cost savings can shorten the payback period for your new loan. The quicker payback can reduce your risk if you're not sure how long you'll be living in the home. Bankrate's Refinancing Calculator will help you figure out the months to recoup costs (payback period) on your loan.

I'll be the first to tell you that I don't know where interest rates are headed. That said, we're either at or near the end of a Federal Reserve cycle of lower interest rates. There's a lot more risk of rising interest rates on your variable rate loan than hope for a continuation of lower rates. Read Greg McBride's feature to learn why you shouldn't be deceived by low ARM rates.

Do some comparison-shopping between fixed rate mortgages, adjustable rate mortgages (ARM), home equity loans and home equity lines of credit. A 5/1 ARM will have a fixed rate over the first five years of the loan term and then becomes a one-year ARM. The problem with a 5/1 ARM is the risk that rates rise over the next five years and your mortgage adjusts to a much higher interest rate with no prospect of refinancing.

-- Posted: July 24, 2002

Read more Dr. Don columns
See Also
Everything you need to get a home equity loan
Cash-out refinancing -- here's how it works
Financial advice glossary
More Dr. Don stories

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