Debt Consolidation With a Cash-Out Refinance

 August 21, 2000, Revised July 18, 2007, Reviewed February 25, 2011

“I need $50,000 to refinance credit card debt. 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?”

Cash-Out Refinance Versus Second Mortgage

The most important factor determining whether a debt consolidation is cheaper using a second mortgage or a cash-out refinance is the current level of interest rates relative to those at the time the first mortgage was taken out. If current levels are lower, a cash-out refinancing is likely to be better because the new first mortgage can have a lower rate than the existing one. If current rates are higher, on the other hand, a second mortgage is likely to prove cheaper. However, many other factors enter the equation. Here is a more complete list.

* 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.

Using a Refinance Calculator

All these factors are pulled together in a 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 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.

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