Debt Consolidation Via Home

When using your home as a collateral to obtain funds for a debt consolidation loan you have three options:  Home Equity Loan, Home Equity Line, Cash-Out Refinancing.

  1. Home Equity Loan – A home equity loan is obtained when a homeowner users his/her home as collateral for a specific amount of money.  The maximum dollar amount an individual is may borrow is up to their lender.  However, most lenders used to allow between 90% to 100% of the homes appraised values less any liens (payment of debts) owed on the home. Home equity loans are normally considered second mortgages and are referred to as Close End Home Equity Loans. Close Ended means you pay a fixed annual percentage interest rate. The annual interest rate you would pay on a home equity loan is about double the interest you would pay on a Home Equity Line or a first mortgage.  Second mortgages are being offered at double the interest rate of a first mortgage in the current market environment. These rates may make considering a cash-out refinancing, first mortgage, or using your Home Equity Line of Credit a better option (for cash-out refinancing refer to option three).
  2. Home Equity Line – The second type of financial instrument a homeowner my use to consolidate their debt is obtaining a Home Equity Line. A home equity line is essentially a Home Equity Loan except it is Open ended. This means the money that is borrowed is subject to a variable annual percentage interest rate. This interest rate is usually based of the prime rate plus one. The prime rate can be found in the Wall Street Journal or online.

The longer an individual remains in their home the more equity they accrue.  Prior to the housing market crash the average percentage increase of an individual’s home was ~6% over the past 45 years.  An individual’s market value of their home was greater than their purchase price.  The increase in market value plus the payments which made reducing the principal of your home loan create the equity in your home.  Due to this increase in the home value banks allow individuals to withdraw up to a predetermined percentage of the homes equity as a line of credit against their home.  The lender determines this credit limit by using calculations which utilize a percentage of your homes appraised value as the main variable.  An example of this calculation appears below:

Example: Johnny purchased a home in 2003 for $150,000.  In 2006 his home was appraised in 2006 at $200,000.  He wants to obtain cash by borrowing from his home equity line.  The bank informed him that they will only allow up to 50% of the home’s appraised value as a  home equity line.  Additionally, Johnny owes $30,000 on his mortgage.  The available cash to borrow is as follows:

  • Home Appraised Value: $200,000
  • Banks Maximum %: 50%
  • % of Appraised Value Johnny is able to borrower: $100,000
  • Amount Johnny owes on home and liens: $ 30,000
  • Johnny’s available funds to borrower: $ 70,000

3. Cash-Out Refinancing- What is Cash-Out Refinancing?  Cash-Out Refinancing is a homeowner utilizing their home equity line to obtain cash to pay off debt.  Cash-out refinancing may be obtained through two methods. The borrower may obtain it through refinancing their home (creating a new first mortgage) or by appling for a second mortgage.

Based on the example above Johnny has $170,000 in equity.  In order to pay off his debts from he wants to borrow $100,000.  Johnny has two options:

 a.  Johnny may apply for a second mortgage to obtain the $100,000.  We do not recommend this option.  The rates of a second mortgage are estimated to be double that of the annual percentage rate of refinancing a borrowers original loan (first mortgage) with the additional $100,000 in the loan.

b. Johnny’s best option in this scenario is to refinance the current mortgage at a newly negotiated annual percentage interest rate with the $100,000 included in the loan.

In these tough times you may want to select a second mortgage because it is appears cheaper than refinancing your home.  Many people believe due to the cost of refinancing their home that it is a wiser decision to obtain a second mortgage due to their being no upfront fees.  We would like to illustrate how this is a fallacy and demonstrate how much much more money the borrower may actually pay on a second mortgage.

Example 1 (Second Mortgage):

Johnny obtains his loan through a second mortgage because he does not want to pay for refinancing charges.  Here are the variables:

Value of Home                                                                $200,000

Loan Amount                                                                  $100,000           

Annual Interest for Second Mortgage:                             10%

Number of Years on Loan:                                                       30

Property Tax Rate:                                                                   1.25%

PMI:                                                                                                0.50% 

Based on the above scenario Johnny would pay the following for his second 30 year mortgage loan:

Interest Payments:                                                         $193,426

Taxes:                                                                                   $  75,000

Second Mortgage Loan:                                                  $100,000

Total:                                                                                       $368,426

Example 2 (Refinance First Mortgage):

Johnny obtains his loan through refinancing his first mortgage.  Here are the variables:

Value of Home                                                              $200,000

Loan Amount                                                                 $130,000           

Annual Interest for Second Mortgage:                           5.0%

Number of Years on Loan:                                                    30

Property Tax Rate:                                                                 1.25%

PMI:                                                                                              0.50%

Refinancing Costs Upper Limit of Value of home:     6.00%

Based on the above scenario Johnny would pay the following for his second 30 year mortgage loan.  

Interest Payments:                                                          $114,483

Taxes:                                                                                    $  75,000

Second Mortgage Loan:                                                  $100,000

Total for mortgage:                                                           $319,483

Refinancing Costs Upper Limit:                                    $  12,000

Total:                                                                                       $331,483

The difference between refinancing your mortgage and obtaining a second mortgage is roughly $37,000.  (Please note we estimated the  refinancing cost at the upper most dollar limit you would pay to refinance your home.)

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