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Column Delivered August 21, 2000,
Revised September 6, 2002
�I need $50,000 to remodel my house.
Is it better to refinance my existing mortgage (with a balance about
$140,000) into a new $190,000 mortgage, or should I borrow the extra $50,000
with a home equity loan.?�
Every homeowner
in need of extra cash faces this question.
To answer it, you must consider several factors, including:
* The
interest rate and points you have to pay to refinance the first mortgage,
compared with the same costs for a second mortgage.
* Any mortgage
insurance requirement on the new first mortgage.
* The interest
rate, mortgage insurance, and period remaining on the term of the existing
first mortgage.
* The term you
select on the new first relative to that on the new second.
* The amount of
cash you need.
* Your
income-tax bracket.
* The length of
time you expect to remain in your home.
* The interest
rate you can earn on savings.
All these
factors are pulled together in calculator (3d), Refinance
to Raise Cash or Take Out a Second Mortgage. This
calculator computes all costs of both options over a future time period
specified by the user. It also
shows a break-even interest rate on the second mortgage -- the highest rate you
can pay on the second and come out ahead of the refinance option.
The second
mortgage is the less-costly option if it is available at an interest rate below
the break-even rate.
Consider your
case. You have a $140,000 first
mortgage and you need $50,000. The
average age of most refinanced mortgages is a few years, so I'm assuming you
acquired yours two years ago, at 7 percent for 30 years, without mortgage
insurance.
Example 1
assumes you are in the highest income tax bracket (39.6%) and can earn 5% on
your investments. Your house is now worth $213,000. A new loan for $190,000 plus settlement costs will require
mortgage insurance. I�m assuming the insurance will continue during the entire
5 years you expect to remain in your home.
The new first mortgage would be for 30 years at 8.25% and one point.
The second mortgage for $50,000 plus costs would be for 15 years at 11.5%
and one point.
The break-even rate on the second mortgage is 18.25%, well above the market rate of 11.5% for
the second. Over 5 years, the
second would cost $11,361 less than refinancing the first.
Example 2 is
the same, except that I assume you can afford a 15-year term on the new first
mortgage cash-out. The break-even rate on the second would fall to 16.86%, and
the savings on the second would drop to $8,982.
Example 3 is
the same as Example 2, except that I assume you are in the 15% tax bracket.
The break-even rate on the second mortgage would drop to 14.98%, and the
savings to $8,230.
Example 4 is
the same as 3 except that I assume that your house will appreciate by 5% a year,
resulting in termination of mortgage insurance on the new first mortgage after
18 months. The break-even rate on the second would fall to 13.21%, and
the savings to $4,021.
Example 5 goes
one step further and assumes that marked recent appreciation in the value of
your house eliminates the need for mortgage insurance altogether. The break-even
rate on the second would drop to 12.41% and the savings to $2,138.
Borrowers who
acquired mortgages a few years ago at rates significantly below the current
market are likely to do better taking second mortgages than refinancing.
But older mortgages carrying higher rates can be a different story.
For example,
lets make all the assumptions of Example 1, but instead of having a 7% 30-year
loan from 1998 we assume you have a 10% 30-year loan from 1990.
The break-even would be 9.98%, or below the market rate on the second,
and refinancing would save you $2,467 over 5 years compared to the second.
If we apply the
assumptions of Example 5 to the 10% mortgage, the breakeven on the second would
be 3.81% and the savings from refinancing $17,106.
But don't rely
on generalizations because no two situations are identical. Use the
calculator to find the answer that applies to your precise situation.
Copyright Jack
Guttentag 2002
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