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Refinancing for a home addition

Dr. Don TaylorDear Dr. Don,
We bought our home for $148,000 in 2001 and switched to a 15-year mortgage early last year at 5.25 percent interest. We currently owe approximately $128,000 on the mortgage. With the recent boom in this area's real estate market, homes now go for more than double what we paid for our home and the homes are smaller than ours and on less land. We would like to stay in this home but add on a room or two.

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My question is: Would it pay for us to have the home value reassessed, take a cash-out option and refinance with a fixed 30-year mortgage, using the cash (from equity) to pay for the home improvements or additions? One of my concerns is that with a home equity loan, or second mortgage, we would have less time to pay and bigger payments. And do we have to claim the cash we get from the equity as income for tax purposes?

Does it make more sense to just sell this home and move into another larger home? We realize whatever way we do this, our taxes, etc. will increase. We live in Southern California about one hour away from Bakersfield. -- Rose Refi

Dear Rose,
What bothers me is that you've only been in this house for four years and you're already considering your third mortgage. Closing costs on first mortgages are expensive and you're changing horses too often. That said, the money's spent on the closing costs for the prior mortgages and you might as well figure out what's right for you now.

Look at total costs including closing costs and interest expense when comparing mortgage alternatives. When in doubt go for the longer term. Barring a pre-payment penalty, you can always make additional principal payments on a 30-year mortgage but the large payments associated with a 15-year mortgage are contractual. It sounds like this may be a problem with your current mortgage and at least part of the reason why you're considering replacing it with a cash-out refinancing with a new 30-year mortgage.

A cash-out refinancing with a 30-year fixed rate mortgage will give you much lower monthly payments than combining your current 15-year mortgage with a home equity loan, but the 30-year amortization will mean high total interest expense and higher closing costs.

You can get a home equity loan structured just about any way you want it. That includes getting a 20-year amortization or a 30-year amortization with a balloon payment after 15 years on a home equity loan. Compare rates and closing costs on the home equity loan against those for a traditional first mortgage.

Living in a house during a major addition project isn't much fun but I'd lean toward adding on vs. moving, as long as it didn't give you the biggest house in the neighborhood or put your expected real estate value outside what's normal for your neighborhood.

Sell the house and move to a bigger place and you could pay 6 percent in real estate commissions on top of closing costs for the mortgage on your new home. A for sale by owner approach could work for you, but there are costs to that too.

When you borrow against the equity in your home, you don't have to declare the loan proceeds as income for tax purposes. You haven't realized a profit, you've borrowed money.

-- Posted: Feb. 16, 2005




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