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
