Pros, cons of credit line vs. fixed-rate refinancing


It's an eyeball-grabbing number for anyone interested in real estate: Nearly 3 out of 4 homeowners who refinanced through Freddie Mac from July to October "cashed out," often walking away with thousands of dollars of tax-free money.

Cash-outs are hardly new, but the proportion of refinancers using the technique to pay for consumer expenditures or investments - 72 percent - is at its highest level in more than five years.

One key reason for the trend is that, compared with the spiraling costs of home-equity credit lines, fixed-rate cash-out refinancing into 30-year or 15-year mortgages look smart.

Some equity credit lines carried starting rates below 4 percent a year ago. Yesterday, a typical "prime-plus-one" (prime bank rate plus 1 percent) credit line starts at 8 percent. If, as expected, the Federal Reserve keeps bumping short-term rates upward in the months ahead, equity lines could float to about 8.5 percent or higher.

Contrast that with a fixed-rate cash-out. Say you need $100,000 for a down payment on a second home or to pay for a business venture. Say you've also got at least $300,000 in net equity in your house, creampuff credit scores and qualify for the lowest fixed rates. You should be able to find a 30-year fixed rate refinancing at 6 percent to 6.25 percent or a 15-year fixed rate at 5.5 percent to 5.75 percent. Because you've got loads of equity, your lender should have no objection to a cash-out yielding you the $100,000 you need.

Refinancing with a cash-out now has another strong point: Long-term interest rates appear to be headed for a slow but steady rise. Locking in 6 percent money yesterday might look like a brilliant move a year or two down the road, when rates could be significantly higher.

If you opt for refinancing rather than a floating-rate equity line, you will have lots of company. Freddie Mac chief economist Frank E. Nothaft predicts that homeowners will pull a stunning $204 billion from their properties this year alone through cash-out refinancing of their primary mortgages. During the quarter from July to October, $60.4 billion in equity was liquefied into cash through refinancing, according to Nothaft.

A couple of downsides to cash-outs are obvious. By definition, they mean you carry more debt secured by your house, which puts your most important asset at greater risk if you lose your job, get sick or run into other financial difficulties.

And more debt means higher monthly payments, especially if you opt for a 15-year payback term. Can you handle the extra monthly burden? Do you have reserves or contingency plans to manage your monthly mortgage, credit card and other consumer debt payments?

Another negative is that refinancing typically costs much more in settlement and loan-origination fees than home-equity lines, unless you have your closing charges rolled into the note rate.

To be fair, home equity lines are by no means obsolete in yesterday's market, where short-term rates are rising faster than long-term rates.

There are several very good reasons to strongly consider an equity line. At the top of the list would be convenience and control. Once you've been approved for a specific amount on a line, it is your call how much you draw down and when you receive the cash.

You pay interest only on the amounts you've pulled out, not the full amount of the approved limit. Most lines allow immediate access to additional funds up to the limit using credit cards or checks. Usually, there is no hassle in drawing down new funds.

A $100,000 credit line might be a far more flexible financial management tool for you than a $100,000 lump-sum cash-out refinancing. If you need to use only $20,000 of the $100,000, that's all you draw down. The $80,000 balance functions as a cost-free contingency fund, ready for action whenever you truly need it. Your monthly rate on your $20,000 might be 8 percent, but the rate on your contingency balance is zero percent.

Finally, don't forget that a growing number of banks allow you essentially to have your cake and eat it too: You can convert your floating-rate equity line into a fixed-rate equity loan or second mortgage whenever you choose. You can float your rate like a butterfly for a while on modest balances, then lock in for the long term when you draw down to the limit.

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