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Refinancing into a home equity loan

Chris Farrell Sep 15, 2010

Question: We are opening a line of credit from our home’s equity, some of which we plan to use to pay off our mortgage. The Mortgage is a 20 year at 5.75% (fixed) with 9 years to go. The LOC is for 10 years at 2.75%. I think it’s a good deal to pay it off this way and possibly use some of it to pay for college tuition for my child. What do you think? Erik, Lexington, MA

Answer: I’m not a fan of this financial maneuver. We’ve been getting a number of emails from folks thinking about retiring their higher-rate fixed rate mortgage for a lower-rate home equity line of credit. Yes, you’ll save on interest costs for awhile (although you also have to take into account fees). But I don’t think the risks are worth the potential savings.

Here’s why: Most home equity lines of credit are floating rate loans. Right now, rates are exremely low and it’s hard to see yields increasing anytime soon. But over the next several years? What if rates on your line of credit go to 6%, 7%, and 8% at some point when the Federal Reserve is worried about an outbreak of inflation? Sounds crazy, right? But it could happen.

For example, I was doing some bond market research the other day. It was striking how in the early ’80s when the yield on the 10-year Treasury bond peaked well above 15% investors never imagined the 10-year Treasury bond trading in its current 2.5% range.

Of course, rates could stay low the whole time of the loan. But a great deal of financial security is built into a loan with a fixed interest rate. You’ll also pay fees to refinance the loan, another expense that will eat away at your return.

No, a better strategy is to focus on getting rid of the mortgage quicker. You don’t have that long to go before you own the home free and clear. One simple technique to speed up the day of ownership is to make 13 mortgage payments a year rather than 12.

I also don’t really like parents tapping into their home equity to help defray the cost of college. Again, the reason is that I don’t think it’s worth the risk. Home equity loans have been a source of financial pain for so many homeowners after the real estate bubble burst.

It makes more financial sense for your student to borrow for college. Student loan repayment terms are also very flexibile. Loan payments can be deferred. Monthly payment obligations can be reduced. The same isn’t true with mortgage payments. The bill needs to be paid on time or there’s trouble brewing on the home front.

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