Dear Dr. Don,

I have eight years left on my mortgage and want to know if it is worth refinancing to take cash out. I am considering refinancing to 10 years at 3.875 percent with closing costs of \$2,600, which would be rolled into the mortgage. I’d then take out approximately \$12,000 for home improvements. The interest rate on my existing mortgage is 4.99 percent and my mortgage balance is approximately \$104,000.

— Alicia Arrange

Dear Alicia,

I used Bankrate’s mortgage calculator and your numbers to analyze whether it makes sense for you to do a cash-out refinancing on your home. I broke the cash-out refinancing into its component parts so you can review the impact of each part.

The table shows that it doesn’t make sense to refinance if you aren’t taking cash out. You’ll get a lower interest rate, but you’ve extended the loan term, so the total interest expense is about the same as your existing mortgage. Add in the \$2,600 in closing costs and you’re better off in your existing loan (\$22,349 vs. \$24,754).

Refinance scenarios
 Existing mortgage Refi Remodel Combined (refi + remodel) Combined w/additional principal payments Loan amount: \$104,000 \$106,600 \$12,000 \$118,600 \$118,600 Interest rate: 4.99% 3.875% 3.875% 3.875% 3.875% Loan term (months): 96 120 120 120 107 Monthly payment: \$1,316.14 \$1,072.95 \$120.78 \$1,193.73 \$1,193.73 Additional principal payment: \$ – \$ – \$ – \$ – \$122.40 Total monthly payment: \$1,316.14 \$1,072.95 \$120.78 \$1,193.73 \$1,316.14 Total payments: \$126,349.11 \$128,754.20 \$14,493.91 \$143,248.11 \$140,385.35 Total interest: \$22,349.11 \$22,154.20 \$2,493.91 \$24,648.11 \$21,785.35 Closing costs: \$ – \$2,600 N/A \$2,600 \$2,600 Total expense: \$22,349.11 \$24,754.20 \$2,493.91 \$27,248.11 \$24,385.35

But you want to tap your home’s equity for \$12,000. There are a couple of ways to do it. A cash-out refinancing is one you’ve touched on. You’re getting a low rate on the remodeling money, but you have to pay closing costs to get it.

I look at it two ways — one where you take the full 10 years to pay off the note, and the other in which you make additional principal payments each month so your monthly cash flow hasn’t changed from your existing mortgage.

By making additional principal payments of \$122.40 each month, you reduce the term of the loan to 107 months, or just a month shy of nine years. That reduces your total interest expense to less than the interest expense on the existing first mortgage. It also has your total cost about \$2,000 more than your existing first mortgage, while financing \$12,000 in home improvements.

The other way to tap your home’s equity is with a home equity line of credit or a home equity loan. At this writing, the Bankrate national average for a HELOC is 5.54 percent, and a home equity loan is 7.27 percent. HELOCs are variable-rate loans, and typically require only interest payments in the early years of the loan.

A home equity loan is a fixed-rate loan and the loan is fully amortized, meaning the monthly payment is large enough to cover both the interest expense and the repayment of principal over the loan term. The table below shows the comparison between these two loans.

Home equity loan vs. HELOC
 Home equity loan HELOC 1 Loan amount: \$12,750 \$12,750 Interest rate: 7.27% 5.54% Loan term (months): 120 120 Monthly payment: \$149.82 \$138.62 Total payments: \$17,978.23 \$16,634.86 Total interest: \$5,228.23 \$3,884.86 Closing costs: \$750 \$750 Total expense: \$5,978.23 \$4,634.86

1) The HELOC assumes a constant interest rate over the life of the loan and a fully amortized monthly payment.

Closing costs for both loans are estimates.

So it’s clear, given the rates and costs used as inputs, that the cash-out refinancing trumps the idea of keeping the existing first mortgage and financing the remodeling costs with either a home equity line or loan.

You’ll need enough equity in the property to qualify for the cash-out refinancing, but that’s based on the appraised value of the property and the lender’s requirements for the loan-to-value ratio.

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