refinance

Use cash-out refinancing to pay down debt?

Don TaylorDear Dr. Don,
I have a conventional 7/1 adjustable-rate mortgage at 5.125 percent with no private mortgage insurance, or PMI, that will adjust in 2015. I live in South Florida where housing prices have taken a big hit, and I'm not sure I have 80 percent loan-to-value, or LTV, in my home.

A pencil-search appraisal from a Realtor friend shows my home value to be between $265,000 and $275,000. I owe $230,313. I have $20,000 in debt that I would like to pay off. Right now, I'm making minimum payments totaling $600 a month.

I plan to stay in my home seven to 10 years. What would be my best option to lower my monthly expenses? I see my options as: refinance to another 7/1 ARM, get a home equity loan for the $20,000, if I have enough equity, or get a new cash-out mortgage for $250,313.
-- Carlos Consolidate

Dear Carlos,
You're not repaying the debt. You're restructuring the debt. By that, I mean you're using mortgage debt to replace the other debt. You still owe the $20,000, just now you owe it to the mortgage lender.

First, a pencil appraisal is an informal appraisal of a property using available county records with no site visit. Using the range of the pencil appraisal gives you a loan-to-value of 83 percent to 87 percent. That's the ratio of your mortgage to your home's value. You'd need to be at 80 percent or less to avoid paying PMI on the loan.

A cash-out refinancing will increase the loan-to-value even more, in this case to 90 percent to 94 percent. You're going to have a hard time convincing a lender to provide you a cash-out refinancing that will give you the $20,000 for your debt. A home equity lender isn't going to like these ratios either.

If you have a good credit history, you could refinance your current mortgage balance to a new 7/1 ARM at or near 3.1 percent. You'd free up money in your monthly budget in two ways: You'll have a lower interest rate on your mortgage, and you'll extend the loan payments back out to 30 years. Even with that, you'd save about $63,000 in pretax interest expense over the life of the loan, assuming interest rates stayed the same over the life of the loan, as shown in the table below.

Mortgage options
Existing 7/1 ARMNew 7/1 ARMDifference
Loan balance:$230,313.00$230,313.00
Interest rate:5.125%3.1%
Loan term (months):312360
Loan payment:$1,337.48$983.47$354.01
Total interest expense:$186,981.00$123,738.00$63,243.00

You would still have to pay PMI even if you're just refinancing the outstanding loan balance, but PMI doesn't last forever. Use the reduction in your monthly mortgage payment to pay down your $20,000 in debt over time. If you pay $900 per month on your debt (your current $600-per-month payment plus an additional $300), you should be able to get that under control in short order.

It's not exactly the solution you were hoping for, but it does get you to a better place with your mortgage refinancing, which frees up money in your monthly budget to work on paying down your outstanding debt.

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