Equity Line of Credit or Refinance?

Does it make MORE sense to get a home-equity line of credit? Or refinance your existing mortgage with cash-out at a higher rate than you currently have?
This is a great question. And the answer is not always the same. It depends on many factors, including 1) How much equity are you looking for? 2) What are you going to do with the equity? 3) What is your current loan amount? 4) Will you qualify for a home equity line of credit? 5) What is the rate you will receive for a home equity line of credit? The answers to these questions will help you make the right decision, because sometimes, refinancing your first loan with cash out at a higher rate than you currently have IS the right answer! And if you can’t figure it out on your own, then call me as I deal with these scenarios all the time!
Let me give you a scenario, but realize that each scenario runs on its own merit:
Let’s say you currently owe $250,000 on a first mortgage. Your current interest rate is 2.875% on a 30 year fixed. Your principal and interest payment is $1141 (based on an original loan of $275K). The estimated value of your home is $500,000. You are interested in paying off all your credit card debt of $65,000 and improve your home using an additional $75,000. SO the total amount of cash you would like is $140,000. What is the right move?
Let’s examine. We have answered the first 3 questions. We would have to determine #4 and #5. Do you qualify for a home equity line of credit? Not every lender provides stand-alone home equity lines of credit. Banks generally do, but here is the rub on banks. They are VERY conservative on value AND conservative on debt-to-income ratios. So…although there seems to be enough equity ($250K first loan + $140K home equity loan = $390K total divided by a value of $500K = loan to value of 78%), banks generally allow for up to 80% loan to value on HELOCS…but let’s say they appraise the property for $475K for example. This will make the loan-to-value 82% and you may be out of luck!. But let’s assume the bank appraises for $500K, what rate will you get? Assuming your FICO score is excellent (let’s use 750), the rate on HELOC’s are determined by adding the Current Prime Interest Rate plus a margin (risk) determined by the bank. The Prime Rate today is 3.25% and let’s say the margin this bank determines is 1.25%. So your start rate will be 4.5%. The FED meets every 6 weeks to determine if the Prime Rate should adjust, and when it adjusts, your HELOC rate adjusts with it. It is NOT a fixed rate; it is variable. Now that we know the rate, your principal and interest payment will start at $709 per month ($140K at 4.5%).
So we have determined that currently, you are paying $1141. And with a new HELOC, your payment will be $709. Total payment of $1850. Do you qualify? Banks use more strict debt-to-income ratios for HELOCS (generally up to 43%) vs a regular loan (generally up to 49%). But let’s assume you qualify. The next question is, what would be your payment on a single loan cash-out refinance? Let’s say that your new rate on a 30 year fixed would be 3.5%! But your current rate is 2.875%!! Let’s continue with the analysis. Your principal and interest on a new loan of $390K (Current 1st of $250K plus $140K cash out) would be $1751! Versus $1850 by keeping your current loan and adding the HELOC. You would actually save nearly $100 a month simply by taking the 3.5% rate AND…because it is a FIXED RATE, you don’t have to worry about the HELOC going up as the FED adjusts the Prime Rate!
In this scenario, it makes more sense to refi at 3.5% rather than keep your current 2.875% rate and add a HELOC starting at 4.5%! Every scenario is different, so call me to work the numbers for you! Reach me at 661-705-2500!