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The best way to use home equity to raise $25K

Dr. Don Taylor, Ph.D., CFA, CFP, CASL
Don Taylor

Dear Dr. Don,
My wife and I own our home free and clear. It's worth approximately $275,000. Our credit rating is excellent, and we don't have any other loan payments. All autos, credit cards, etc. have a balance of zero. We would like to borrow approximately $25,000 to $30,000 to update our home. We plan to live in this house for the next 10 to 15 years and want to pay off the new loan over the next decade.

Should I look for another mortgage or use a home equity loan? I want the best interest rate I can get, without a lot of extra fees. What type of loan should I ask for?

-- Mike Makeover

Dear Mike,
With your excellent credit, you should be able to get a very competitive interest rate. And you have a number of loan options.

The key here is in the closing costs and fees. Since there's no outstanding first mortgage, you may face some additional closing costs with a home equity loan or home equity line of credit, or HELOC, that you wouldn't otherwise face with this loan. Home equity loans and lines typically have closing costs in the hundreds, not thousands of dollars.

Bankrate's 2012 national average for closing costs on a $200,000 fixed-rate mortgage is $3,754. A cash-out first mortgage for just $25,000 shouldn't have closing costs that high, but it still can be expected to be in the thousands. It's also going to be hard to find a willing lender to loan just $25,000 for a cash-out first mortgage. You won't have that issue with the home equity loan or line.

Bankrate's national average for a home equity loan is, at this writing, 5.03 percent for a HELOC and 5.99 percent for a home equity loan. That compares with 3.66 percent for a new 30-year fixed-rate mortgage and 2.94 percent for a 15-year fixed-rate mortgage. A 10-year mortgage should be slightly lower than the 15-year, but not by much. Cash-out first mortgages typically have a risk premium built in to the interest rate that would raise the rate by about 0.5 percent. So the 10-year fixed-rate cash-out mortgage would effectively be in the 3.44 percent range.

The table below shows a possible scenario with my estimates on closing costs. I'd suggest talking to a lender in your market, prior to applying for a loan, for estimates of closing costs and interest rates on the different types of loans. You could then use Bankrate's mortgage calculator to come up with a table that reflects your reality.

What's the best way to get $25K loan?

Home equity loan HELOC Cash-out first
Loan amount $25,000.00 $25,000.00 $25,000.00
Interest rate 5.99% 5.03% 3.44%
Loan term (months) 120 120 120
Interest-only payment on HELOC $104.79
Payment (amortized) $277.43 $265.53 $246.51
Total interest expense (pretax) $8,291.09 $6,863.66 $4,581.51
Estimated closing costs $1,000.00 $1,000.00 $2,500.00
Total financing costs (pretax) $9,291.09 $7,863.66 $7,081.51

HELOCs are typically interest-only in the early years of the loan. I've shown that loan payment both ways, but would recommend that you make the high amortized monthly payment that would pay off the loan over its 10-year life. The table shows the cash-out first mortgage as being the least expensive, pretax, but you still have to find a willing lender.

Your ability to fully utilize the mortgage interest deduction may also influence your choice of loans. The cash-out first mortgage will still have the lowest total financing costs, but that advantage shrinks because of the higher tax deductions associated with the higher interest loans.

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