I recently received this letter from a consumer who is contemplating refinancing her loan. The interesting thing is that instead of wrapping credit card debt into a first mortgage, which is far and away the usual course of action, this consumer is interested in transferring her home equity loan onto a credit card.
“Here’s our situation. We built a home and closed on it in May 2000. The interest rate was 7.62 percent for a 15-year loan. The mortgage amount was $101,000.
“We already had a few miscellaneous bills hanging around and then we bought a few more things for the house. We then decided to consolidate everything, which came to $11,300, in a home equity loan so we could deduct the interest.
“Now, we want to refinance our home at a much lower interest rate, but the home equity loan would become part of the new mortgage. We don’t want to finance things like a used John Deere garden tractor and attachments for 15 years. We would like to have our monthly mortgage payment as low as possible.
“Can we transfer the $11,300 home equity loan to a credit card? Then, we could refinance our mortgage, which now has a balance of about $97,000. After we close, we could then transfer the $11,300 back to a new home equity loan?”
The interesting thing about this question is that it gets to the heart of what good money management is all about – how do you make your money work harder for you?
For consumers who carry thousands of dollars in credit card debt, it’s tough enough to find other credit card companies that will allow you to transfer balances onto cards with low introductory financing rates. With today’s super-low interest rates, I’ve seen credit cards offering to transfer balances to cards with interest rates as low as .9 percent or 1.9 percent.
(Be aware that teaser rates for balance transfers might not apply when you use the checks the credit card company sends. If the check isn’t made out to a Master Card, Visa, Discover Card or another major credit card company, you may get charged whatever rate the credit card company has on that card. Read the fine print.)
Is this a better deal than refinancing the entire loan with a 5/1 adjustable rate mortgage (ARM), with an interest rate of 5.50 that’s tax deductible? Probably. Let’s work through the numbers.
Generally speaking, the higher your marginal tax bracket, the better off you are itemizing on your federal tax return. If your mortgage rate is 5.5 percent and you’re in the 28 percent tax bracket, your net interest rate (after the deduction) is around 4 percent.
So if you’re paying less that 4 percent on your balance transfer, you may seem to be coming out ahead than if you’re paying off a home equity loan. Let’s look at our consumer’s $11,300 balance.
If you’re paying 5.5 percent interest on the $11,300 balance, on a 15-year loan, you’ll pay $92.33 per month, and pay a total of $5,319.48 in interest by the time the loan is paid off. On a 30-year amortization, you’d pay just $63.16 per month, but $11,797.56 in total interest over the life of the loan.
But let’s say you’re lucky enough to transfer the $11,300 balance to a credit card that has a 1.9 percent interest rate for life. On a 15-year amortization, you’d pay $72.20 per month, and $1,695.39 in interest over the life of the loan. On a 30-year amortization, you’d still pay $41.20 per month, with total interest of $3,533.99 over the 39-years of the loan.
Clearly, the lower interest rate is better, but I’ve never seen a credit card company offer 1.9 percent financing for 30 years. If you’re really lucky, you might get that for 6 to 9 months. More likely, you’ll be offered 4.99 percent or 6.99 percent or even 8.99 percent financing for the first few months of the loan.
So what about the idea that you’ll just transfer the balance of the home equity loan for a month (thus securing the cheap interest rate) and then get a new home equity loan a few months later to pay off the credit card.
Interest rates on home equity loans are tied to the prime rate, which is tied directly to the federal funds rate Alan Greenspan has lowered 9 times (and probably will have lowered more by the time this column is published). As of this writing, the federal funds rate was at 2.5 percent. Add on 3 percent for profit, and you can get a home equity loan for about 5.5 percent.
Since this is the same rate as the 5/1 ARM, the question is, what’s the benefit in getting a separate home equity loan?
Our consumer thinks the loan will be amortized over 5 years instead of 15 or 30 years. If that’s the case, she’d pay $215.84 per month and just $1,650 in interest over the 5 years. On the other hand, home equity loans aren’t generally fixed, and the interest rate can fluctuate. So, there’s some risk in choosing a home equity loan.
And if you choose a standard 15-year mortgage rather than a 5/1 ARM, the interest rate will be higher, say 6 percent, rather than 5.5 percent. That would make a home equity loan less expensive.
And, all this hinges on good credit. If you have good credit, you’ll have access to the best credit card and home loan rates, with the fewest fees and points.
But the cheapest solution is actually the easiest: Frequently second mortgage and home equity lenders will reassign the subordination agreement they have with your current primary lender to another lender, allowing you to refinance your original loan but keep your current home equity loan.
By working it all out, it appears that this consumer has found a way to make her money work harder for you. But you won’t know that until you break down your loan options and analyze what combination of loan programs will give you the result you seek.