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Replacing a Mortgage With a Home Equity Loan

By Jeff Brown
Today’s rock-bottom interest rates are spurring a flood of mortgage refinancing. But many homeowners face a serious roadblock: thousands of dollars in closing costs.

It’s tempting to pay off the old loan with a home equity line of credit instead of a new mortgage, since many home equity loans don’t have closing costs.

But although this can work under some circumstances, it may not be the best option in today’s market because of the risk you’d face with higher payments later.

With a conventional mortgage, appraisal fees, private mortgage insurance, title-search charges and other closing costs can be a problem if you don’t have enough cash to pay them.

And because many of these costs are fixed, even if you borrow a modest amount, you could end up paying thousands of dollars in fees, undermining the benefits of refinancing.

For example, $4,000 charge for closing costs would be 8 percent of a $50,000 mortgage. Even if you could afford the closing costs and could cut your loan rate by a couple of percentage points, that could still make a refinancing uneconomical.

To see how long it takes a lower monthly payment to offset closing costs, check out the Refinance Breakeven calculator.

It is possible to skirt this problem by taking out a home equity loan with no fees.  Unfortunately though, it probably wouldn’t pay to do this today with a fixed-rate home equity “installment” loan, as many are charging around 9 percent, according to the survey. The standard 30-year fixed-rate mortgage averages only around 5 percent, making it much more attractive for refinancing, even with closing costs.

So what’s left then?  How about a home equity line of credit, or HELOC. A HELOC is a revolving loan that works much like a credit card. But rather than receiving a lump sum, as is the case with an installment loan, you borrow what you want, up to your credit limit.

Many HELOCs advertise starting rates of 4 percent or less. A homeowner with an old mortgage charging 6 or 7 percent could cut monthly payments dramatically by replacing it with one of these low-rate credit lines.

Well-known firms such as LendingTree (Stock Quote: TREE) and PNC (Stock Quote: PNC) provide home equity loans, but use the search tool to see what local banks in your area may offer.

Interest payments on home equity loans are generally tax deductible, just like interest paid on ordinary mortgages. Many HELOCs require that you only pay interest charges each month, giving you the option of forgoing principal payments if money is tight.

And because the HELOC is a revolving credit line, you always have the option of borrowing more, so long as you stay below the limit. That means you can, in effect, take money back out of your home whenever you want, without the hassle and expense of getting a new loan.

So it all sounds great, right? But there is a serious problem -- because HELOC rates are variable, you can’t be sure the savings will last. The loan that charges 4 percent today might charge 6, 7 or 8 percent sometime later.

Many HELOCs figure monthly adjustments by adding a fixed “margin” to the prime rate. With today’s prime at around 3.25 percent, a HELOC with a 3.5 percent margin would charge 6.75 percent.  You’d probably do better refinancing with a fixed-rate mortgage at around 5 percent.

If you cannot afford the closing costs, the best option might be to tighten your belt in order to pay a little extra on your mortgage every month. These “prepayments” would help you pay the loan off early, thus reducing your interest costs. Use the Mortgage Payoff calculator to see the effect.

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