mortgage

Refinance mortgage with home equity loan?

Don TaylorDear Dr. Don,
My credit union has recommended that I take out a home equity loan at a fixed rate of 3.8 percent. That would be lower than the rate of 4.75 percent on my current mortgage, which still has 27 years to go and $249,000 left to pay.

With a refinance, I was told I could lower it to a 20-year fixed-rate equity loan and it would only cost me $50 more per month. It sounds great to get seven years taken off my mortgage, but I worry that this is too good to be true. I'm told there are no closing costs. What do you think? Should I move forward on this?

Thanks,
-- Michael Mortgage

Dear Michael,
At first, it reads like a slam-dunk. But keep in mind that there's really no such thing as a zero closing cost mortgage. Instead, mortgages charge closing fees in other ways, such as a higher interest rate on the mortgage.

The good news is you'd be capturing interest savings in two ways: in the lower interest rate on your mortgage and on the shorter loan term. The table below shows how you can save $86,463.84 in pretax interest expense over the next 20 years by refinancing with the 20-year fixed-rate home equity loan.

Save on pretax interest expense

Current loan20-year home equity loanDifference from current loan
Loan amount:$249,000$249,000N/A
Interest rate:4.75%3.8%0.95%
Loan term (months):32424084
Payment:$1,365.22$1,482.78$(117.56)
Total payments:$442,330.87$355,867.03$86,463.84
Total interest:$193,330.87$106,867.03$86,463.84

I show you paying an extra $117.56 a month instead of the $50 you mention in your letter, but that could be because you don't have exactly 27 years remaining on your existing mortgage. If you can afford the additional expense, you'll gain a lot of interest savings.

Ask yourself if you can get a lower rate from a different lender, even if that means paying closing costs on the mortgage. A 0.25 percent lower interest rate on $249,000 represents a pretax interest savings of $7,745.72 over the 20-year life of the new loan. That assumes you hold the loan for the full 20 years. You might be better off paying the closing costs upfront to capture a lower interest rate.

If you really want to see some savings, look at refinancing into a 15-year mortgage at 2.97 percent, which is Bankrate's national average at the time of this writing. It's an extra $350.74/month versus your existing mortgage, but it reduces the pretax interest expense by $133,000 versus your existing mortgage.

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