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Dear Dr. Don,

We have owned our home for five years. It’s currently valued at $325,000. We’d like to borrow $50,000 to $70,000 for college costs. Can we take out a second mortgage at a lower interest rate, or must we take out a home equity loan? We are considering paying it back within 10 years, with an earlier repayment plan in mind. If mortgage rates are lower than home equity rates, is it possible to borrow at a lower rate and retain a second mortgage?

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We would be more comfortable with a fixed rate, but would consider an adjustable-rate mortgage if we could get the first five years locked in at the initial rate. Does this seem reasonable or possible?

Thanks,

— Puzzled Paula

Dear Paula,

You’re incorrectly differentiating between a second mortgage and a home equity mortgage. A home equity mortgage is most often actually a second mortgage. The only time it’s not is when there’s no first mortgage outstanding when taking out the home equity line or loan.

As I write this, the Bankrate national average for a 30-year fixed-rate mortgage is 4.01 percent, while the home equity line of credit, or HELOC, is at 4.78 percent and the home equity loan is at 6.15 percent. Although you might get a lower rate in your local market, you aren’t likely to get a second mortgage as low as 4.01 percent.

What I don’t know is how much your home is worth. That is key. Assuming you have solid equity in the home after five years, you have several choices when borrowing against that equity. These options include a cash-out first mortgage, a home equity loan and a HELOC. If you’re doing a cash-out first mortgage, you can capture that lower first-mortgage interest rate, but you’ll also have higher closing costs associated from the new first mortgage.

Your loan choice can also influence how much financial aid your child can get. The Free Application for Federal Student Aid, also known as FAFSA, doesn’t count the equity in your home. By contrast, it will count cash sitting in your bank account. A HELOC gives you access to the equity as needed over time. Some private schools consider the equity in your home when determining financial aid.

You might take a 5/1 ARM with a cash-out first mortgage, but I don’t see a compelling reason to do that. The typical HELOC is an adjustable-rate loan with interest-only minimum payments in the early years of the loan. The typical home equity loan is a fixed-rate amortized loan, meaning the monthly payment covers the interest expense and the repayment of principal over the loan term. Remember that additional principal payments made on any of these loans reduce interest expense and shorten the life of the loan.

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