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Ask Dr. Don
By
Don
Taylor,
Ph.D.,
CFA
•
Bankrate.com |
Cash-out refi or home equity loan?
Dear Dr. Don,
We want to access the equity in our home. Is it
better to refinance or to get a home equity loan?
Thanks,
Mike Mortgage
Dear Mike,
How you plan to spend the money, how long you want the money for
and your attitude toward taking on interest rate risk are all factors
that influence what type of financing is right for you.
A home equity line of credit (HELOC) is a variable-rate
loan. The interest rate is based on the pricing index plus a spread
to that index. The typical HELOC is based on the prime rate plus
a spread, prime + 0 percent, prime + 1 percent, etc. Prime is currently
4 percent but will change over time with changes in the Fed Funds
Rate. You can track the prime rate on Bankrate's Rate
Watch feature.
A HELOC, at least in the early years of the loan,
is revolving credit, like a credit card. Paying down the loan frees
up your credit line for future borrowing. Homeowners can replace
high interest credit card debt with home equity debt at a lower
interest rate and the interest expense may be tax deductible. In
the early years of the loan the minimum payment is just the monthly
interest expense.
In contrast, a home equity loan has a fixed interest
rate and a fixed payment that covers both the interest expense and
principal repayment. A home equity loan is a good choice for large,
one-time purchases such as home remodeling or repair, paying for
a wedding or buying a car.
Refinancing your first mortgage with cash out is another
option. You can choose between a fixed rate mortgage, an adjustable
rate mortgage (ARM) or a hybrid that is fixed for a set number of
years and then adjusts -- such as a 5/1 ARM. You may be able to
get a longer term for a first mortgage then you can with a second
mortgage.
Doing a cash-out refinancing may reduce the interest
expense on your existing first mortgage. Bankrate's Refinancing
Calculator can help you determine if refinancing your first
mortgage makes sense. Use your existing loan balance and current
market rates to determine how many months it will take you to recoup
the closing costs on a refinancing. If you plan to be in the house
longer than the payback period, then refinancing can save you money.
But if you can't save money by refinancing your first mortgage,
then it makes more sense to borrow using a HELOC or a Home Equity
Loan.
HELOCs and home equity loans typically involve much
lower closing costs than a first-mortgage refinance. If, for example,
the closing costs on a HELOC are $500 and the closing costs on a
new first mortgage are $3,500, the extra closing costs raise the
effective interest rate on your loan.
Economists see interest rates trending higher this
summer with anticipated increases in the Federal Funds rate. A higher
Fed Funds rate will mean a higher prime rate so you'll see short-term
interest rates rise over time. HELOCs and ARMs will move higher
with these higher short-term interest rates. Your interest expense
and monthly payments will move higher with your loan rate. If you
plan on being in the house for a long time and want to spread the
loan repayment over 15 to 30 years, then odds are you'll be better
off in a fixed-rate loan.
Bankrate's Your
Personal Mortgage Adviser interactive worksheets will also walk
you through these mortgage decisions.
-- Posted: June 8, 2004
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