Home equity loan may beat cash-out refinance

Don TaylorQuestionDear Dr. Don,
We currently have a 30-year fixed-rate mortgage at 5 percent on our house with a loan balance of about $460,000. We paid $670,000 for the house with a $200,000 down payment. The house should appraise for about $700,000.

We have been in our house only 18 months and are considering our options to pay down about $10,000 of credit card debt and to raise some cash to begin remodeling our house. The projects we have in mind range from efficiency upgrades (windows, doors, tankless water heater, etc.) to cosmetic upgrades (kitchen, baths, flooring, etc.).

We feel we need to start soon on the efficiency projects to take advantage of the current government incentives and, of course, we would like to enjoy the cosmetic upgrades for a longer period while we are in the house. Our plans are to be in the house at least 10 to 15 years to get our kids into or through college. But I retire from the military in two years, so second career options could foul that plan.

I do expect to be able to find work in the area following retirement from the military. If we need to move sooner, we feel the upgrades will be a necessity to get the best price on the house.

Which vehicle would be most beneficial -- refinance, HELOC or home equity loan? Some initial queries suggest that we can get the most cash from a refinance, but the rates they are quoting are from 5.25 percent to 5.5 percent for 30-year fixed-rate loans. It also appears that banks are not too keen on HELOCs or home equity loans based on the amount of cash they initially quote.
-- Michael Mortgage

AnswerDear Michael,
With an uncertain tenure in the house, it's hard to recommend a cash-out refinancing of your first mortgage. Besides the higher closing costs associated with a new first mortgage, you're looking at raising the mortgage rate on the $460,000 loan balance by 0.25 percent to 0.5 percent.

Depending on the conforming loan limits where you live, you could also see higher interest rates if your new loan is considered to be a "jumbo loan." You can learn more about conforming loan limits in the Federal Housing Finance Agency Web page "Conforming Loan Limit."

Start out by putting together a budget for your remodeling and efficiency projects. (The cynic in me would have you double that number.) Add the 10 grand in credit card debt to that budget. Once you have that number, you have a better idea whether you can make a home equity line or loan work. Read the Bankrate feature, "Tax breaks for home energy upgrades," for additional background information on the tax breaks.

By my estimate and your figures, you can raise about $100,000 in a cash-out refinancing before the lender is going to require private mortgage insurance. You'd have a little more lending room in a home equity line or loan, but as you point out, lenders are reluctant to get too aggressive in lending limits on these loans.

Your goal should be to minimize the total interest expense on an after-tax basis. That gets a bit convoluted when you don't know how long you'll be in the house.

I suggest using Bankrate's loan comparison calculator to compare a new first mortgage with keeping the existing first mortgage and adding a home equity loan. Use the current loan balance and remaining loan term for the existing first mortgage and leave out the closing costs on the existing mortgage.

I guesstimated the closing cost numbers in the calculator and wound up with the existing mortgage and the home equity loan being the better choice on a pretax basis. The after-tax comparison would depend on the deductibility of the interest expense on the home equity loan. The table below goes beyond the calculator inputs to include the total interest expense. You can find total interest expense yourself using Bankrate's mortgage payment calculator.

Home equity vs. refinance
Cash-out first mortgageExisting combined with home equity loanExisting first mortgageNew home equity loan
Mortgage amount$560,000$560,000$460,000$100,000
Interest rate5.5 percent5 percent7.41 percent
Loan term (months)360342360
Loan amortization360342360
Estimated closing costs$2,800$ -$800
Monthly payment$3,179.62$3,219.05$2,525.99$693.06
Annual percentage rate5.545 percent5.445 percent5 percent7.491 percent
Total interest expense (including estimated closing costs)$587,463$553,391$403,889$149,502

To my thinking, this gives you some confidence that keeping with your existing mortgage and borrowing with a home equity loan can actually be less expensive than a cash-out refinance of your first mortgage. That's especially true if you might be out of the house in two years.

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