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Debt Consolidation With a Cash-Out Refinance

Debt Consolidation With a Cash-Out Refinance

August 21, 2000

I need $50,000 to refinance credit card debt.  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. 

Most borrowers with mortgages acquired a few years ago when rates were significantly lower, fare better with a second mortgage than with a cash-out refinance.  However, to know for sure, you must consider a host of 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 a new calculator, Refinance to Raise Cash or Take Out a Second Mortgage, developed with Chuck Freedenberg of DecisionAide Analytics. 

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.

It is evident that 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



Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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