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
incometax 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 breakeven 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 lesscostly option if it is available at an interest rate below
the breakeven 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 breakeven 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 15year term on the new first
mortgage cashout. The breakeven 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 breakeven 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 breakeven 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 breakeven
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% 30year
loan from 1998 we assume you have a 10% 30year loan from 1990.
The breakeven 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
