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

Cash to remodel

Dear Dr. Don,
I have a $44,000 mortgage at 7 percent and am looking to refinance. I'm also in the midst of remodeling the kitchen and looking to take equity out of the home to cover the cost. I've considered a home equity loan to cover the cost of the remodel and only refinance the original $44,000 mortgage.

Is it possible to take a home equity loan in the amount of my $44,000 mortgage and the $20,000 remodel cost and use the proceeds to pay off the first mortgage and just have a $64,000 home equity loan at a much lower monthly payment for the same term that remains on the mortgage?

If this is possible, why would anyone refinance?
Thanks,
David Domain

Dear David,
Assuming your home is worth more that $80,000, you can take out a home equity loan for $64,000, use $44,000 of the proceeds to pay off your first mortgage and have $20,000 left over to pay for the kitchen remodel. The assumption that the home is worth more than $80,000 keeps the loan-to-value ratio of your loan below 80 percent, and private mortgage insurance shouldn't be a consideration.

There's a difference between a home equity line of credit and a home equity loan. A HELOC is a variable rate loan, and its interest rate will reset with changes in the interest rate that the loan is priced on. Most HELOCs are priced at a spread to the prime interest rate. You can track the prime rate and other key interest rates on Bankrate's Rate Watch page.

A home equity loan is a fixed rate loan. The interest rate on a home equity loan is typically higher than the interest rate on a 30-year fixed-rate mortgage because most home equity loans are second mortgages, and the lender faces more risk than the first mortgage lender.

HELOCs have very low rates right now because the Federal Reserve has been in an easing cycle, lowering short-term interest rates for financial institutions. The current easing cycle has taken place over the last two years and is nearing an end. The table below compares three financing options over a 10-year horizon. You can use Bankrate's Mortgage Calculator to put together a table of your own with interest rates from your area.

Financing using Option 3, the 10-year HELOC, saves you more than $10,000 in interest expense over its life only if interest rates stay where they are and you pay down the principal each month as if it were an amortizing loan.

HELOCs aren't amortizing loans, so the required monthly payment is only the interest expense. If you don't make principal payments as you go along, you'll end up with a balloon payment at the end of the loan term and a lot higher total interest figure. Option 3 shows a monthly payment that amortizes the loan to $0 at the end of the 10-year term, assuming that the interest rate stays constant over the 10-year life.

A fixed-rate mortgage locks in your rate and amortizes your loan over a period. HELOCs give you a lower interest rate initially, but you accept the risk if rates go higher. Many HELOCs have floors (minimum rates) and ceilings (maximum rates) that limit the upside and downside of variable-rate financing.

Try Bankrate's new mortgage decision tools, especially its fixed vs. adjustable rate tool, to help you decide what option is right for you.

-- Posted: Nov. 27, 2002