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Frequently asked questions about home equity loans

What is cash-out refinancing?
Cash-out refinancing is a transaction in which a new mortgage is issued that is greater than the outstanding unpaid principal balance of the previous mortgage. Cash-out transactions allow homeowners to spend the equity they have accumulated in their homes. It differs from a home equity loan or line of credit in that it's a new mortgage, not a second loan against the equity in a home. Both cash-out refis and home equity loans provide vehicles for taking cash from the home's equity.

Should we refinance or get a home equity loan to provide cash for home repairs?
Whether it makes more sense to refinance and take cash out or borrow using a home equity loan depends on your financial goals, the interest rates on the new loans, the interest rate on your existing mortgage, your marginal income tax rate and your ability to use the mortgage interest deduction on your income taxes.

The primary difference between these two options is time. Typically, a cash-out refinance is for a period of 30-years, while a home equity loan is for five to 15 years. If you are going to refinance the existing loan and the cash-out portion as a new 15-year mortgage, than this will probably provide better terms than the home equity loan, although there will be some closing costs involved. If you are planning on refinancing to a new 30-year loan, but can afford a 15-year home equity loan, then the latter is preferable.

We want to consolidate our debts and are considering a mortgage to refinance up to 120% of the value of our home. How do these loans work and is it a good idea?
Financing 120% of the home's value means that you will owe more than the house is worth. Depending on how home values are increasing in your area, the fact that a 30-year mortgage pays down principal slowly means that you will be unable to sell your home for many years to come. If your debt payments are too high, or the interest rates are exorbitant, and you are having trouble paying your bills, then this is definitely an option to consider.

It is important to note that you will lose some of the tax advantage when you refinance a home for more than its value. The proceeds of the refinancing (that portion greater than your current mortgage) must go to either home improvements or the purchase of a second home to be fully deductible. If the cash is used for something other than that, such as to pay debts, the IRS imposes limitations. The total home equity debt is limited to the smaller of: $100,000 or the fair market value of your home less the amount owed on the original mortgage. Interest on amounts over the home equity debt limit generally is treated as personal interest and is not deductible.

Once a person gets a mortgage, is there a length of time one must wait before refinancing?
Unless there is a prepayment penalty clause in a mortgage, you can refinance anytime.

How do I know when it's time to refinance? With the new lower interest rates, is it worth refinancing?
To refinance, you need to lower your monthly payments by enough to cover your closing costs on the loan before you sell the house. A no-cost refinancing is tempting, but it really isn't free. You either pay a higher interest rate than you would otherwise or wind up including the closing costs in your new mortgage. Don't just look at the lower payment and commit to the refinancing. Understand how the lender is covering the closing costs. Bankrate's refinancing calculator can help you determine the number of months it will take to recoup your costs.

I'd like to refinance our home and take cash out to pay off loans and credit card bills and end up with additional cash to invest in property. My husband just wants to leave things alone and pay our bills as we go along. Which is the wiser choice?
Mortgage loans on a primary residence are the least expensive form of borrowing for most consumers. That's especially true if you can use the mortgage interest deduction on your state and federal income taxes. Assuming you can use the mortgage interest deduction, the effective rate on the new mortgage should be less than even your auto loan. You can estimate your effective after-tax rate on your mortgage by multiplying the interest rate by one minus your tax rates.

If you go past an 80 percent loan-to-value ratio, the lender will require private mortgage insurance on the loan. That means that you have to limit your list of things to do with the cash from the refinancing. Keeping the home equity component of the loan under $100,000 is also important for the deductibility of interest payments. IRS Publication 936 Home Mortgage Interest Deduction, has more on this aspect of the refinancing.

When you roll an auto loan into a mortgage, you're taking 30 years to pay for the car. That's also true for the credit card debt and the student loans. You can shorten the term of your mortgage by making an additional principal payment each year. It will accelerate the mortgage payoff by about six years.

In taking cash out to invest in property, you're taking on the risk that the appreciation in the property won't outpace your interest expense. There are very few sure things in this world, so make sure you are comfortable with the risks inherent in this approach before loading up on mortgage debt.

What are the tax implications of getting cash out when refinancing?
Cashing out of your main home is a great tax strategy if you're using the proceeds to pay off other debt on which the interest is not deductible.

An individual is allowed to take out up to $100,000 from their principal residence in addition to the original debt used to buy the home, and deduct the interest charged before it is repaid. For more information on this, check out IRS Publication 936 Home Mortgage Interest Deduction.