||Ask Dr. Don
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?
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.
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
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.
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