Q: We own a home in Silver Spring that’s worth at least $500,000. We have as a first
trust a 30-year, fixed-rate loan with a balance of $200,000 at a rate of 6.25 percent. We also have a home-equity line with a $100,000 limit and a $20,000 balance. The rate on the line is equal to the prime rate plus half a percentage point.
We plan on putting an addition on the house that is estimated to cost $125,000. My husband thinks we should finance the addition with the equity line by going to the bank and asking for a higher limit. His logic is that we will spend only what we need and when we need it. I think we should refinance our first trust and get cash out.
What do you think?
A: I understand and agree with your husband’s logic, but I think you are wise to do both. That is, refinance your first trust and have an equity line available.
Let me explain.
First, if you follow your husband’s plan, you will have $200,000 in a fixed-rate loan and $125,000 in a variable-rate loan. This would mean that more than 38 percent of your total mortgage debt would be subject to market fluctuations. That’s like having an investment portfolio that is too heavily weighted in risky stocks.
In the short term, we can expect the rate on your equity line to rise a bit more. Over a period of many years, it’s anyone’s guess as to where it the rate will go.
If you look at market rates, refinancing makes compelling sense. As of this writing, a zero-closing-cost, 30-year, fixed-rate refinance carries a rate that’s less than 6 percent. Prime plus ½ percentage point is equal to 6.25 percent and likely to continue to rise.
By refinancing, you can kill not one or two, but three birds with one stone.
First, you can lower the rate on your outstanding balance by at least 1/4 percentage point.
Second, you can take cash out to pay for the addition at a lower rate than what’s being offered with the equity line.
Third, you can eliminate interest-rate risk by fixing the entire ball of wax for 30 years.
But as I said, your husband has a point. The cost of an addition often changes as construction progresses. In paying for the addition entirely with cash-out refinancing, you would have to know the exact cost of the addition ahead of time, which is unlikely. You may end up short at the end of the day. Or you may end up borrowing more than you want.
My advice is to refinance your first trust for $330,000. This would give you enough cash to pay off the first trust, pay off the equity-line balance and leave you with about $110,000 in cash. Keep the existing line open, and pay the rest of the addition cost with the equity line.
If your estimate is close, you would only need $15,000 from the line.
This is, indeed, a small and acceptable portion of your total debt that would be subject to interest-rate changes. Because the amount of cash received from the refinancing will be a little less than the total cost of the addition, you know that you won’t be borrowing too much. The equity line allows you to borrow the last bit when you need it.
The only downside to this approach is the carrying cost of the $110,000 cash. This money won’t be needed all at once, but you will need to pay the interest as soon as the refinancing closes.
In my view, the interim interest cost is a small price to pay when the alternative is to have almost 40 percent of your mortgage debt subject to the whims of the Federal Reserve Board.
Henry Savage is president of PMC Mortgage in Alexandria. Contact him by e-mail (email@example.com).