December 29, 2014 in Home Equity

Dear Dr. Don,
I’m wondering whether my husband and I should refinance our home. The current mortgage is $212,000 at 3.75 percent. We would like a cash-out refinancing, using $50,000 to buy a small house in Mexico. The interest rate on the new mortgage will be at 4.75 percent. We’d pay a higher rate because of our credit scores. The bank’s appraisal of our current home is $345,000. I don’t want to sign the paperwork if this is a bad decision.

— Lucy Loans

Dear Lucy,
I can’t speak directly regarding an investment in Mexican real estate, but I don’t like the idea of using a cash-out refinancing to fund the home purchase.

Instead, you should look into a home equity line of credit or home equity loan to raise the money.

The reason for this approach is twofold. First, why pay extra interest on your $212,000 first mortgage balance to borrow an additional $50,000?

The table below illustrates why you should stick with your current mortgage and use a home equity line or loan to borrow the $50,000. I’m assuming a rate of 6.15 percent for a home equity loan. The rate of 4.81 percent (recently the national average) for a home equity line of credit, or HELOC, would increase savings.

Cost of equity loan vs. cash-out refi

  Loan amount Interest rate First year’s interest expense
Existing first mortgage $212,000 3.75% $7,950
Home equity loan $50,000 6.15% $3,075
Combined $262,000   $11,025
Cash-out first mortgage $262,000 4.75% $12,445
Amount saved with equity loan     $1,420

Secondly, a new cash-out first mortgage will have much higher closing costs than a home equity line or loan. Bankrate’s recent national average for closing costs on a new first mortgage is $2,539. Closing costs on a HELOC should be minimal. The closing costs on a home equity loan should be somewhere between the cash-out refinancing and the HELOC.

A HELOC is an adjustable-rate loan, with interest-only payments during the draw period, usually the first 10 years of the loan. At the end of the draw period, the loan typically becomes an amortized loan, meaning the monthly payment is increased to a level that covers the repayment of the loan balance over the remaining loan term.

A home equity loan is a fixed-rate loan, with amortized payments over the loan term. I’d lean toward the HELOC, but I suggest you work at paying down principal during the draw period.

Get more news, money-saving tips and expert advice by signing up for a free Bankrate newsletter.

Ask the adviser

To ask a question of Dr. Don, go to the “Ask the Experts” page and select one of these topics: “Financing a home,” “Saving & Investing” or “Money.” Read more Dr. Don columns for additional personal finance advice.

Bankrate’s content, including the guidance of its advice-and-expert columns and this website, is intended only to assist you with financial decisions. The content is broad in scope and does not consider your personal financial situation. Bankrate recommends that you seek the advice of advisers who are fully aware of your individual circumstances before making any final decisions or implementing any financial strategy. Please remember that your use of this website is governed by Bankrate’s Terms of Use.