FAQ about trading equity for cash
By Bankrate.com

Leveraging the equity in your home can be a wise financial move, especially when interest rates are low. For some homeowners, the liquidity offers new opportunities for investing, while for others paying off high-interest debt saves thousands of dollars in interest and on taxes. Everyone's situation is different, but here are the more frequently asked questions from Bankrate's virtual mailbag, with answers from our experts.

What is cash-out refinancing?

I want cash for home repairs. Should I refinance my mortgage or get a home equity loan?

I want to pay off a home equity line of credit (HELOC) and pull out additional cash. Which is better: a 10-year line of credit at a variable rate, a 20-year fixed-rate home equity loan or a cash-out refinance?

Once a person gets a mortgage, is there a length of time they have to wait before they can refinance?

How do I know when it's time to refinance? With the new lower interest rates, is it worth refinancing?

We need to consolidate our debts and are considering a mortgage to refinance up to 120 percent of the value of our home. How do these loans work and is it a good idea?

I'd like to refinance our home and take cash out to pay off loans and credit card bills and end up with additional cash to invest in property. My husband wants to leave things along and pay our bills as we go along. Which is the wiser choice?

What are the tax implications of getting cash out when refinancing?

What is cash-out refinancing?
Cash-out refinancing is a transaction in which a new mortgage is issued that is greater than the outstanding unpaid principal balance of the previous mortgage. Cash-out transactions allow homeowners to spend the equity they have accumulated in their homes. It differs from a home equity loan or line of credit in that it's a new mortgage, not a second loan against the equity in a home. Both cash-out refis and home equity loans provide vehicles for taking cash from the home's equity.

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I want cash for home repairs. Should I refinance my mortgage or get a home equity loan?
Whether it makes more sense to refinance and take cash out or borrow using a home equity loan depends on your financial goals, the interest rates on the new loans, the interest rate on your existing mortgage, your marginal income tax rate and your ability to use the mortgage interest deduction on your income taxes.

A good method for deciding is to look at the "weighted APRs" of the loan alternatives. "Weighting" the APRs is easy: You take the interest rate of each loan and multiply it by its portion of the total debt. Let's say a homeowner owes $100,000 on an existing mortgage and wants to spend $50,000 on renovations. If the homeowner takes out a $50,000 home equity loan or line of credit, the homeowner would owe a total of $150,000: two-thirds of it in the form of the original $100,000 mortgage, one-third of it from the new home equity debt. So to get the weighted APRs, you would multiply the rate of the $100,000 mortgage by two-thirds and the $50,000 equity loan by one-third (see table below for example).

Choose the alternative that has the lowest weighted APR with payments that fit your budget. Because APRs include estimates of closing costs, this method adjusts for the differences in closing costs among the alternatives.

Substitute your own values into this table to help you decide which type of loan is right for you. Use the Bankrate loan calculator to determine the payments when constructing your worksheet.

In the example, a cash-out refinancing gives you a lower monthly payment, but higher overall payments since the homeowner would be paying for 30 years. If the homeowner makes an additional principal payment of $250 each month on the refinancing alternative, the entire loan will be paid off in 2018 with total payments of $258,534.

Home equity loans are paid off over a shorter period than mortgages, which increases the monthly mortgage payments. Since you can make additional principal payments on the refinancing to bring down the loan balance, the shorter term of the home equity loan isn't an advantage.

A home equity line of credit (HELOC) is revolving credit, so you can pay off the home repairs and borrow against the line again without having to take out another loan. Since the interest on personal loans isn't tax deductible and the interest expense on a mortgage or home equity loan typically is tax deductible you can save money by using the revolving credit line.

A HELOC is a variable-rate loan, and minimum monthly payments won't amortize the loan. You have to have the financial discipline to make monthly payments that will pay off the loan over its term. Otherwise, you end up with a rather nasty balloon payment due at the end of the loan.

The payment presented for the HELOC alternative in the table is based on the rather unrealistic assumption that the interest rate never changes, but it will pay off the loan over its 15-year life.

Finally, if you can use the interest-expense deduction on the home equity loans, you should be able to use the deduction on the cash-out refinancing. This IRS flowchart will help you determine if you can use this deduction. IRS Publication 936 has the complete information on home mortgage interest deductions.

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I want to pay off a home equity line of credit (HELOC) and pull out additional cash. Which is better: a 10-year line of credit at a variable rate, a 20-year fixed-rate home equity loan or a cash out refinance?
Borrowing money you don't need is expensive. But, if you can invest the additional cash at a higher after-tax rate of return than the after-tax cost of debt, it can be to your advantage to borrow the money and invest it until you need it. To find out the after-tax cost of debt, multiply your loan rate by the quantity one minus your marginal federal tax rate minus your state tax rate. Taking this approach to invest in the stock market isn't for the faint of heart, especially if the value of your stocks heads south. Paying back money that you lost in the market is never fun.

The best option is to roll the refinancing up into a new first mortgage, preferably a 15-year fixed rate mortgage. You'll have higher closing costs on a first mortgage than you would on a home equity loan, but reducing your interest expense in repaying the old HELOC will make it worthwhile and you'll have financed your cushion at a lower rate as well.

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Once a person gets a mortgage, is there a length of time one must wait before refinancing?
Unless there is a prepayment penalty clause in a mortgage, you can refinance anytime.

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How do I know when it's time to refinance? With the new lower interest rates, is it worth refinancing?
To refinance, you need to lower your monthly payments by enough to cover your closing costs on the loan before you sell the house. A no-cost refinancing is tempting, but it really isn't free. You either pay a higher interest rate than you would otherwise or wind up borrowing the closing costs. Don't just look at the lower payment and commit to the refinancing. Understand how the lender is covering the closing costs. Bankrate's refinancing calculator can help you determine the number of months it will take to recoup your costs.

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We want to consolidate our debts and are considering a mortgage to refinance up to 120 percent of the value of our home. How do these loans work and is it a good idea?
Financing 120 percent of the home's value puts you upside-down in your home, meaning you owe more than the house is worth. That makes it extremely difficult to sell, especially if you have to pay a real estate agent 6 percent of the selling price. If you think landing upside down in a car is trouble, try being upside down in a house. You can't count on rising home prices to dig you out of that hole quickly.

Plus, you lose some of the tax advantage when you refinance a home for more than its value. The proceeds of the refinancing must go to either home improvements or the purchase of a second home to be fully deductible. If the cash is used for something other than that, such as to pay debts, the IRS imposes limitations. The total home equity debt is limited to the smaller of: $100,000 or the fair market value of your home less the amount owed on the original mortgage. Interest on amounts over the home equity debt limit generally is treated as personal interest and is not deductible.

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I'd like to refinance our home and take cash out to pay off loans and credit card bills and end up with additional cash to invest in property. My husband just wants to leave things alone and pay our bills as we go along. Which is the wiser choice?
Mortgage loans on a primary residence are the least expensive form of borrowing for most consumers. That's especially true if you can use the mortgage interest deduction on your state and federal income taxes. Assuming you can use the mortgage interest deduction, the effective rate on the new mortgage should be less than even your auto loan. You can estimate your effective after-tax rate on your mortgage by multiplying the interest rate by one minus your tax rates.

If you go past an 80 percent loan-to-value, the lender will require private mortgage insurance on the loan. That means that you have to limit your list of things to do with the cash from the refinancing. Keeping the home equity component of the loan under $100,000 is also important for the deductibility of interest payments. IRS Publication 936, Home Mortgage Interest Deduction, has more on this aspect of the refinancing.

When you roll an auto loan into a mortgage, you're taking 30 years to pay for the car. That's also true for the credit card debt and the student loans. You can shorten the term of your mortgage by making an additional principal payment each year. It will accelerate the mortgage payoff by about six years.

In taking cash out to invest in property, you're taking on the risk that the appreciation in the property won't outpace your interest expense. There are very few sure things in this world, so make sure you are comfortable with the risks inherent in this approach before loading up on mortgage debt.

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What are the tax implications of getting cash out when refinancing?
Cashing out of your main home is a great tax strategy if you're using the proceeds to pay off other debt on which the interest is not deductible.

An individual is allowed to take out up to $100,000 from their principal residence in addition to the original debt used to buy the home, and deduct the interest charged before it is repaid. For more information on this, check out IRS Publication 936, Home Mortgage Interest Deduction.

This strategy is a winner since it allows the homeowner to possibly refinance other debt that may be at a higher interest rate than rates available on a second mortgage, allows the homeowner to receive a tax benefit by deducting the interest on the loan which in effect let's the government pick up part of the tab on the loan repayment, and lastly, it allows the homeowner to remain in his current home which he may feel he would have to otherwise sell to cash out. The rules are different on cashing out of a rental property.

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-- Posted: Jan. 9, 2003