Homeowner Headache: Refi or Equity Loan?

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A big expense looms over you like college tuition, a new car or major home-improvement. You’re short of cash but do have plenty of equity in your home. What’s the best way to get it: refinance the mortgage or take out a home equity loan or line of credit?

In today’s market the home equity line of credit, or HELOC, offers the lowest interest rate, at least at the start. Many begin below 4%, then adjust to 5% or 6% a few months later.

The standard 30-year fixed-rate mortgage averages about 5.2%, and home equity installment loans with three- to 15-year terms charge from 8.3% to nearly 8.8%, according to BankingMyWay.com.

But choosing the best option involves a good deal more than finding the lowest interest rate.

Of course, for any of these moves to work, you must have equity in your home, which means it is worth more than you owe on your present mortgage. To qualify for a new loan you’ll have to show a solid payment record on the old one and a good credit rating.

Then consider the pros and cons of each type of loan.

Cash-out refinancing

This means taking out a new mortgage that is larger than the balance remaining on the old one, so you can pay off the old loan and use the surplus for other expenses.

Spreading the repayment over 30 years can leave you with smaller payments on the extra cash than if you borrowed the same amount with either type of home equity loan, as they generally have much shorter terms. But stretching the payments over more years means paying a lot of interest.

The biggest drawback of a full refinancing is closing costs, which can come to thousands of dollars.

Refinancing to pull cash out of your home may make sense only if you also benefit by getting a lower interest rate than you’re paying on the old mortgage. Use the shopping tool to find better-than-average deals, such as the 5% rate charged by TD Bank (Stock Quote: TD). With the Refinance Interest Savings Calculator you can compare the old and new loans.

Home Equity Installment Loan

These involve borrowing a lump sum at an interest rate fixed for the life of the loan, which is usually three to 20 years. Closing costs may be as low as a few hundred dollars.

But the interest rate is higher than on a first mortgage, mainly because the home equity lender is less likely to get repaid if the property ever falls into foreclosure.

Because you have to pay the loan off faster than with a 30-year mortgage, payments on a given sum may be higher.

These loans are best for homeowners who want to spread their payments over a fairly long period and avoid high closing costs. Find the best installment and HELOC deals with the search tool. PNC Bank (Stock Quote: PNC) has installment loans charging less than 7.3%.

HELOC

Many of these charge no closing costs, and they typically have very low starting rates. After the first few months, rates can be adjusted as often as every month, generally by adding “margin” of 2 or 3 percentage points to the prime rate, currently 3.25% percent. HELOCs often use a “cap” to limit rate increases.

Borrowers usually have the option of paying only the interest charges during a “draw” period that may last for five to 10 years. Because the HELOC is a line of credit, you borrow only what you choose to, up to the maximum allowed.

HELOCs offer lots of flexibility, but carry a risk of higher interest rates later. They are best for borrowers who expect to pay off their loans fairly quickly. IngDirect (Stock Quote: ING) has a HELOC starting at 4%.

For most borrowers, interest payments are generally tax deductible for all three types of loans. Given the single-digit interest rates and deductibility, tapping home equity can be a much better option than credit card debt. Just remember: If you default on payments, you can lose your home.

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

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