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Refinancing for home improvements

Dr. Don TaylorDear Dr. Don,
My husband and I have lived in our home for 26 years and need to do a few major improvements, including a kitchen makeover and a new paved driveway. We estimate costs between $15,000 and $20,000. We owe $36,000 on our home with five and a-half years remaining on the note. The resale value of our home is estimated at $175,000. We also owe $12,000 on a home equity loan with 10 years remaining. Should we refinance one of these to make the improvements? Both are at approximately 6.7 percent interest. Thank you.
-- Sharon Selects

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Dear Sharon,
While you can have more than one home equity loan outstanding, your loans are at a high enough rate to consider doing a cash-out refinancing to pay for the home improvements.

A new first mortgage will typically have higher closing costs than a home equity loan or line of credit. Spending several thousand dollars in closing costs to finance $15,000 to $20,000 in home improvements won't make sense unless the closing costs also help you to get a lower interest rate on your mortgage debt.

One problem with this strategy is that even though you've refinanced at a lower interest rate, spreading the repayment out over a longer time period will dramatically increase your total interest expense. Look to a 15-year loan term vs. a 30-year loan and you'll lessen that problem.

Make sure your home equity loan doesn't have a prepayment penalty if you plan to refinance that loan. It's unlikely that you'll be able to talk your existing home equity lender into adding to your existing loan vs. refinancing.

The table below is a rough estimate of your current situation and a choice between a cash-out refinancing and a new home equity loan to finance the improvements and refinance the existing home equity debt. You can use Bankrate's mortgage calculator to help you construct a table with your actual rates and balances.

a Existing first mortgage Existing home equity Refinancing new home equity Cash-out refinance Cash-out refinance with additional payments
Loan balance:
Loan term (months):
Interest rate:
Monthly payment:
Total interest expense:

There's a host of considerations here, including the ability to pay down the new home equity loan faster once the existing first mortgage is paid off, or the decision to make additional principal payments on the cash-out refinancing so the monthly housing payments are the same for the two alternatives in the early years of the loans.

I think the cash-out refinancing with additional principal payments is the most-attractive option, even after considering closing costs. Try to minimize total cost, considering both interest expense and closing costs. I haven't discussed your use of the mortgage interest deduction on your taxes, but being able to use that deduction will reduce the effective interest rate on your loan and your effective interest expense.


-- Posted: March 28, 2005




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