home equity

Do math before remodeling

Don Taylorq_v2.gifDear Dr. Don,
I need $50,000 to remodel my house, and I want to know if it's better to get a home equity line of credit or a fixed-rate refinance with cash out?

My current, and only, mortgage is at 6.5 percent, and I owe about $112,000 with about 10 years left on the loan. My house is worth about $400,000. I prequalified for a $75,000 HELOC loan at prime plus 1 percent. It's 5.25 percent to start, then a variable rate thereafter, with a $300 penalty if I pay it off before three years and $200 every time I want to draw more money from the credit line.

Is that a good deal? Or should I keep shopping around for a fixed rate? I need advice. Please help.
-- Katia Credit

a_v2.gifDear Katia,
Making the right decision partly depends on how long you plan to take to pay off the remodeling project.

For most homeowners, the goal is to minimize the total interest expense so long as the monthly payments remain affordable. Longer loans have lower monthly payments but typically have a higher total interest expense. Shorter loans have higher monthly payments but usually have a lower total interest expense.

The beauty of the cash-out refinancing option for you is that you should be able to lower the interest rate on your first mortgage while locking in a low, long-term interest rate on the money needed for the remodeling project.

So you're actually making two decisions -- a refinancing decision and a decision about how to finance the remodeling project. If you can get a good rate on the cash-out refinancing, it makes sense to combine the two financings.

Before even applying for a loan, you can use Bankrate's "Rate Search" feature to estimate the cost of a cash-out refinancing. Then use Bankrate's "Savings from refinancing" calculator to test whether it makes sense to refinance your existing first mortgage. If it does, consider bundling the remodeling project in with the refinancing. If it doesn't, look at using separate financing for the remodeling project.

A HELOC is an adjustable-rate loan priced at a spread to an interest rate. The prime rate plus 1 percent you were quoted would put your current interest rate at 4.25 percent because the prime rate is 3.25 percent.

Since you were quoted 5.25 percent, there is probably a floor, or minimum, interest rate on the loan. That should mean your HELOC rate wouldn't move higher until the prime rate moved above 4.25 percent.

You'll also want to know if there is a cap, or ceiling, on how high the rate can go. You can follow changes in the prime rate on Bankrate's "Rate Watch: Track leading interest rates" page.

Typically, a HELOC is interest-only in the early years of the line and eventually converts to an amortized loan. An advantage to a HELOC is its low closing costs when it is a second mortgage on a property.

The $200 cost for a draw against the credit line seems a bit pricey, but the lender wants to keep you from using the line like a checking account. The $200 cost should accomplish that goal. The prepayment penalty of $300 is reasonable for a HELOC.

The Bankrate feature "Choosing loan or line of credit" will help you sort through the differences between a HELOC and a home equity line.

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