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FAQ about trading equity for cash

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, Dr. Don, the Dollar Diva and George Saenz.

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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. IRS Publication 936 has the complete information on home mortgage interest deductions.

-- Updated: April 11, 2005





Home Equity
Compare today's rates
$30K HELOC 4.31%
$50K HELOC 4.06%
$30K Home equity loan 5.05%
Rates may include points

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