||Ask Dr. Don
Second thoughts about second
Dear Dr. Don,
A small company is trying to sell me on taking a second mortgage
home equity line of credit and paying off my first mortgage, a 30-year
fixed rate loan, along with consolidating my other debts.
The loan would total $200,000 with closing costs of
about $6,000. They say I'll save many dollars and pay everything
off early. Can this be done?
It can be done. A better question is, "Should it be done?"
When a second (home equity) mortgage is used to pay off a first
mortgage, the second mortgage effectively becomes a first mortgage.
That's because, if the house was sold, there's no
first mortgage to be paid off before the home equity mortgage holder
gets paid. You should be able to get a better interest rate on a
first mortgage than you can on a second mortgage.
Home equity lines of credit (HELOCs) are variable-rate
loans that are typically written with a 10- to 20-year maturity.
You didn't say how many years you have remaining on your 30-year
fixed rate mortgage, but shortening up the maturity can increase
the size of your monthly payment.
With a HELOC you can choose to make interest-only
payments, but that doesn't pay anything off early and you wind up
with the financial headache of making a large balloon payment at
the end of the loan's term. A HELOC typically has lower closing
costs than a first mortgage. Spending $6,000 to close a $200,000
HELOC isn't a bargain.
Instead, I think you should look at doing a cash-out
refinancing of your first mortgage. That gives you the ability to
consolidate your debt and gives you the lower rates associated with
a first mortgage.
If you're comparing a HELOC with a low introductory
rate to a 30-year fixed rate mortgage, the HELOC will look very
tempting, but that's not a fair comparison. Compare the HELOC to
a one-year adjustable rate mortgage (ARM) and see how they stack
up. Don't forget to consider the fully indexed rate after the introductory
If you don't like the interest rate uncertainty of
an ARM, then you shouldn't embrace the idea of borrowing using a
HELOC. As always you can shop
rates and track
indexes on Bankrate.
There are some potential pitfalls to using mortgage
debt to consolidate credit card and other unsecured debts. When
you don't pay your credit card, you have to deal with bill collectors
and will get a negative comment on your credit report. When you
don't make your mortgage payment, you face those things plus you
could lose your home.
The two principal benefits of using mortgage
debt to consolidate unsecured debt are a lower interest rate and
potentially being able to use the interest expense as a deduction
on your taxes. (Your tax adviser can help you if you're uncertain
about your ability to use the mortgage interest deduction.)
-- Posted: April 15, 2002