Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Second thoughts about second mortgage

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?
Chris Consolidation

Dear Chris,
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 period.

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