The only time we refinanced, we had a loan without closing costs. I wouldn't have done it otherwise. Even so, we had 0 equity when we sold the house a couple years later due to job relocation. In fact we ended up paying $15k out of pocket to sell it, in part because of the stupid economy but also because we had no equity. Haven't recovered yet...

Hi donaldsg,

So many things wrapped into your post... let's gently unwrap & inspect them so you can make an objective decision.

My husband and I are trying to decide if we should refinance our home and take some cash out to pay for a renovation. We've been in the house 7 years and refinanced after 2 because interest rates dropped significantly.

How much cash did you pay, and how many interest rate percentage points (or portion of points) did it get you in savings, and what were the terms you chose (and why)? The details are actually fairly moot at this point (niether smart nor dumb,) but could provide lessons in finance based on how & why your loan got structured the way you did it at that time.

We currently have 25 years left to pay at 5.5% and our monthly payments are $1100 (incl. mortgage insurance and taxes).

We're currently getting clients locked on new 30 FRMs at 4.75% with no discount points (which is not the smartest way to go... but the standard way most people compare.) This would be 0.75% of a savings for you, which is 15.6% off your current interest costs.

15.6% savings is no small chump change... definitely worthy of looking deeper into and doing the math.

The refinancing would be for $138,000 and give us a new 25-year mortgage at 5.0% and monthly payments would be $1450.

I would *DEFINITELY NOT* suggest taking a 25 year term, as it gets no lower rate than a full 30 year term (and what is with 5%???) The shorter term merely takes the money control & safety OUT of your hands by forcing a heavier amortization burden, with no difference in actual interest costs.

Even if you *DID* go 5% (again, *NOT* the smart financial way to go for financially responsible families) that would be a 0.5% savings on $138,000, or $690/year. At 4.75% (better, but still not the best) it would be a savings of $1,035/year. At 4.25% (the lowest available rate coupon,) it would secure $1,725/year in interest savings... all going toward your family's bottom line net worth.

After closing costs, prepayments and paying the balance on our current mortgage we'd get $38,000 cash out to remodel the kitchen (it is the original 1960s one and poorly laid out so it needs it!).

OK... LET'S STOP & REALLY SOAK THIS IN.....

Remodeling the kitchen is a lifestyle comsumption decision... if you are doing so WITHOUT the intention to sell the home within the immediate 6-9 months (which I believe you are not,) it will not result in any serious recoupable increase in the value of your home. (It *does* make the best dollar-for-dollar improvement for a home immediately going up for sale... buyt if you are remaining in the home, not selling, then after a year or so styles shift & change, and future buyers won't be that much more unhappy with the 'relatively new, but not "TODAY" ' kitchen as they would have been with a 'scrap it & completely re-do' kitchen.)

Having said that: THIS IS YOUR HOME! Life is for living, and making money has one purpose (in my opinion) and that is to improve the quality of the life of those who earn it!

YES, it is wise to balance present satisfaction with delayed gratification... but in the end, the end can sneak up on any of us all too quickly & surprising! Life is short; eat dessert first (as they say!)

I'm afraid that if we are paying closing costs 3 times in 7 years we are just being stupid.

I *DO* hear you here... but 'feeling stupid' by looking backwards is due to the possibility of making poor decisions *BACK THEN*... not now. The key to being SMART is to make sure that you learned what you didn't know, and apply it to your CURRENT and FUTURE decisions.

I also feel that with the closing costs (very high in NY) and the prepayments we are effectively paying $11,000 to borrow $38,000.

NY is a bugger in terms of its state equity mortgage tax (1% on all funds taken out,) however none of your prepaids or interest balances are closing costs... so whatever portion of that $11,000 is going toward that, do not let that artificially spook you. Those items are just paying bills in advance that you will have paid for anyway (and the previous lender will reimburse you the funds they had collected for those in the previous process anyway, in 3-4 weeks from closing.)

Am I just being blinded by the upfront costs and this is a good deal, or are we paying too much to borrow?

As a planner, my opinion is that you appear to be being blind to the proper structuring and pricing of your financing to fit your actual financial profile. If you are financing for a longterm product (a 30 or 25 year term) you are clearly gambling that you will *NOT* have any reasonable expectation of another refinance or sale/move in the 7-9 year PLUS future... and if this is the fact, the matching strategy would be to secure the deepest and lowest rate lock you can afford to pay from financed equity. (Rule of thumb, discount points paid up front for a lower rate are recouped within 3-5 years from the locked-in interest savings they create. After the initial 5 years, you are saving pure profits every month.)

BTW, I would really like a new kitchen, but the higher mortgage payment scares me,

Taking the longer amortization schedule of 30 years establishes a much safer burden (assuming you are a responsible money manager, and don't have to be forced to save, normally.)

Hope this all helps!
Dave Donhoff
Leverage Planner

In case it hasn't been pointed out to you...

Your payments go up $350/month. That is $4,200 per year or $105,000 over the next 25 years of mortgage payments. Now, add it the closing costs etc and you are at $116,000. Granted, that is spread over years but it is still a chunk of change.

Personally, I don't think people should borrow money for lifestyle choices. If you want to renovate a kitchen, start saving. You apparently have at least $11k to pay for a refi. You think you can afford at least $4,200 a year in extra mortgage payments, so I'm sure you could save $5k+ per year if you put your mind to it. So within 5 years (less if your really work at it), you could have a paid for kitchen remodel and 20 years left of lower payments. Do you really want to still be paying for a kitchen in 2035?

Also, I agree with Dave about the rate. If you chose to refinance, you should shop around more. We refinanced a couple months ago and got 4.375% on a 30 year fixed.

I agree with Dave's comment on closing costs. Too many people look at the amount of money you bring to the table as closing costs when that is not the case. The amount going to escrow for taxes and insurance is NOT closing costs.

Also, I am not sure what your equity in the home is, but a $38K kitchen in a $150K house (just guessing based on loan amount alone, which could be misleading, I admit), it sounds like too much kitchen for the house possibly. Unless of course you are doing it for your personal enjoyment and not necessarily resale value, in which case you have to ask if you can afford it and won't mind that you may not get the money back. Of course, then there is the opportunity cost of not investing that money elsewhere if your goal is to merely increase your net worth in the long run.

How long do you intend to be in the house? If it is 3-5 years, I would not do it because you probably would not recoup your costs. If it is more like 10 years, you may not recoup the costs necessarily, but your appreciation will be greater at that time (extreme economies withstanding) and you will have gotten 10 years enjoyment out of it.

None of this is scientific like Dave does with return on investment, etc...just what my personal thoughts would be. Good luck with your decision!

Thanks, everyone for all the advice, especially the detailed analysis from Dave.

Here is some clarification: We plan to be in this house for a very long time. We have some money saved to renovate the kitchen, but the cash out would enable us to enlarge the 11x11 kitchen space and add a powder room which we currently do not have on the ground floor of the house (we have 4 bedrooms and 1 bath). So it would not be a 38K kitchen in a 160K (current appraised value) house and presumably the extra space and added bath would give us a reasonable ROI.
And to answer Bill's points about saving and being responsible: we've been in this house 7 years and in that time we've had two children, paid off college loans, made about $30K in improvements, made maximum contributions to our retirement plans and have saved $15K to renovate the kitchen. Our current debts are the mortgage and one car loan. I am as debt averse as you are, Bill, but I have a husband who thinks only good things will happen and I have to keep him reined in :-)

I was able to use Dave's post to convince my husband to shop around some more and I'd like some advice on alternatives.

Option 1) Home equity loan from our credit union with a fixed rate of 6.24% for a 10 year term, and costs are mortgage tax only, or

Option 2) refinance with our current mortgage carrier for a 20 year term at 4.75%, paying closing costs of $5500 and $1920 for points.

At this point I am still undecided about taking on any extra debt to do an addition, but I can see the value in adding the extra space. My husband's arguments are: we may not get such low interest rates in the future and we have an experienced contractor friend/neighbour who is willing to do the work at a reduced rate. Once the economy picks up we may not be so lucky.

From my point of view never hire someone that you know to do anything for you. This is a great way to ruin a friendship. Especially if the neighbor is willing to do the work at a reduced rate. If another job comes along at the full rate yours will be on hold until that job is finished and maybe several after that.

As far as the loan as the above posters have stated you need to look for better rates.

Hi again donaldsg,

I was able to use Dave's post to convince my husband to shop around some more and I'd like some advice on alternatives.

Good... but ugghh!! These are the best offers & advice he's secured???

Option 1) Home equity loan from our credit union with a fixed rate of 6.24% for a 10 year term, and costs are mortgage tax only, or

Even Bernanke has come out & explicitly stated that the Fed is going to keep short-term interest rates low "well into the foreseeable future." Currently, HELOC money is available around Prime (plus or minus maybe 1/4 to 1/2%) That means you can get the money you need (and only draw it *as* needed) at around a net rate of 3%-ish.

That's under *HALF* the costs of the fixed loan, without the more dangerous burden of a forced 10 year repayment amortization*!!!

If you anticipate the ability to save up enough money over the future 10 years to pay for this kitchen addition... then you are likely far better off using a HELOC to do the job (which is also exponentially cheaper in closing costs... from jest a few hundred bucks,) and then using your "savings power" to apply your budget to retiring the HELOC balance.

(* The reason amortization is a responsible person's nightmare is because it removes budgetary control from YOU. Now, this may actually be a good thing for those who know they are "money-management challenged" and if this is true for you I understand... many people are. HOWEVER, if you are indeed a strong income and budgetary manager, then you are far better off keeping 100% control of which direction you send 100% of your money each month (which you can only do when you are NOT constrained by amortization.)

The *BEST* way to eliminate your mortgage (for responsible people,) is to accumulate a side "Mortgage Freedom Account" which grows to the point that you can then stroke out a single large check to extinguish the entire balance at once. EVERYONE ought to eliminate ALL of their home leverage (HOWEVER, never a day nor a dollar earlier than it is SAFE to do so!)

Option 2) refinance with our current mortgage carrier for a 20 year term at 4.75%, paying closing costs of $5500 and $1920 for points.

Again, going the wrong direction on amortization (I am assuming from your self-description you are indeed a tight and responsible budget manager.)

Further, 4.75% is way too pricey on today's market for a 20 year loan.

EVEN FURTHER, if you are planning on staying in this home longer than 5-8 years, and you accept a higher interest rate offer in order to have a lower closing cost (which will entirely be financed by the loan anyway,) then you will be tilting the cost/savings trade-off into the present, and casting your permanent costs into your permanent monthly payments which will NOT get reduced back down after the 5 year breakeven period.

Put it this way....
For approximately every $1 you spend in higher closing costs which results in a lower interst rate....
You save an annual total of about $0.20 in interest costs, permanently, per year.
After 5 years has passed, you CONTINUE to save that $0.20 per year, EVERY year.
SPEND $5,000 in discount points, save $1,000 per year on interest charges. After 5 years, KEEP saving $1,000 per year.

ALTERNATIVELY;
For approximately every $1 you REDUCE in closing costs which results in a HIGHER interst rate....
You SPEND an annual total of an additional $0.20 in interest costs, permanently, per year.
After 5 years has passed, you CONTINUE to SPEND that $0.20 per year, EVERY year.
AVOID $5,000 in discount points, SPEND $1,000 per year in higher interest charges. After 5 years, KEEP SPENDING $1,000 per year, permanently.

Make more sense? This is one of the reasons why it pays to use a properly educated planner to structure your finances, if you aren't familiar with all the variables and how they can really affect you over time.

Cheers,
Dave Donhoff
Leverage Planner

Yeah but doesn't a HELOC have a variable APR? That worries me because that is how some people got into trouble in this mortgage crisis. We've seen offers with teaser rates of 2.75% or 3% for 6 months, but we are gambling that they won't go up, right?

HELOC rates are tied to the Fed Prime (which is 3.25% right now.) This is NOT a free market determinant, but a "decision by committee" of the Federal Reserve, which is a guiding body that sets the short-term interest rates that banks are charged for overnight lending amongst each other.

The Fed Chairman, Ben Bernanke has recently reiterated to the media and markets that he intends to keep the Prime rate low "well into the foreseeable future." This is a very significant quote, because the Fed Chairman uses subtle language changes in their regular announcements to try to give the business markets some advanced clues as to what directions they intend to take well in advance.

WHEN the Fed begins raising their Prime rate, they typically do so (at the fastest) at a rate of about 1/4 of 1 percent per 6-8 week period, and they very very rarely ever go more than 6 consecutive adjustments in a row in a single direction without taking extended "time outs" and/or reversing course for a bit along the way.

THUS... its very reasonable (especially given the Fed's announcements) to expect that we'll see HELOCs remain in that 2-3% range for another 18-24 months minimum... and *IF/MAYBE* at that point, they may begin crawling upwards at a rate of 1/4 of 1% increase every other month... or so... MAYBE.

SO.... YES... I am personally using as much short-term low-cost leverage as I can in my own real estate holdings, and I am guiding and managing my clients who feel comfortable with this in the same path.

Cheers,
Dave Donhoff
Leverage Planner

Thanks, Dave. This is a really good thing to know. We've decided to scale back the plan and borrow or refi a smaller amount to add a bit to the money we have saved for the kitchen remodel so that we can make a few small structural changes to improve the flow of the rooms and add a small eat-in area where we didn't have it before (no addition just reconfiguring existing space). We will look into the HELOC options because if we borrow a smaller amount (we are thinking 15-20K instead of the 38K we were considering) we can pay it off faster and so even if rates rise we should be able to pay off before they get too crazy.

We had a fixed, 15 yr Home Equity loan at 6.5% with an arm of $200,000. We didn't use the HELOC until 2 yrs ago when interest rates dropped to 3%. We took $85,000 of it and paid off the fixed rate loan and used $50,000 to do upgrades and repairs on the house (roof, windows)to prepare the house to sell. We also used $8,000 to pay off a car loan at 4.5%.

We knew we would be selling our house in the next two years and couldn't pass up the savings of the interest on the HELOC.

If I were in your shoes, I'd go with a HELOC. You'd save a bundle even if rates start to go up.

Jane

Donaldsg,

Do you have a credit union where you can borrow the funds you need? One other argument against a refi or HELOC is if you lose one income (assuming you are a two income household) you don't want to lose the house. I would advise saving more so that you don't have to borrow. Paying cash for big projects is a great way to go - no increase to your mortgage payments and no additional loan (HELOC etc) payments.

I agree with Maifleur - do not hire a friend to do the work. You want to go to Angie's list or a similar source that vets contractors. Right now, most contractors are hungry for work and will likely reduce their rates. Has your neighbor been encouraging your husband to do this? (If so, not a good sign.)

Some of us on this forum are financially conservative. Our house was built in 1938 and the kitchen was enlarged in the 50s. When we brought it in 1992, we replaced the linoleum and counter tops, and painted the cupboards.

I can totally understand why you would want a powder room on the first floor though :)

Hi colorcrazy,

One other argument against a refi or HELOC is if you lose one income (assuming you are a two income household) you don't want to lose the house.

Actually, that's one of the biggest reasons FOR taking an equity-rebalancing refinance or HELOC.

If you lose an income, the *LAST* thing you want is to have too much of your safety reserves trapped in the real estate equity, where you can't get to it for ongoing "glide-path" survival costs.

"Cash Is King" when times are tight. The safest, most conservative position will always make sure they have a standard degre of reserves (I believe in 12 months times all living expenses.) If you don't have near that, and you have the ability to qualify to reposition entrapped equity into reserves, prudence is to do so (Pronto! Before "life happens" and you simultaneously no longer qualify, *AND* have surprise emergency needs for the reserves!)

Cheers,
Dave Donhoff
Leverage Planner

"If you lose an income, the *LAST* thing you want is to have too much of your safety reserves trapped in the real estate equity, where you can't get to it for ongoing "glide-path" survival costs. "

While I agree in general, I'm not sure that represents the options for the OP. They aren't talking about borrowing vs using cash reserves. They don't have the money and will be borrowing one way or the other if they do the renovation. They will be increasing their monthly expenses without the benefit of creating additional cash reserves.

Hi billl,

I dunno... our OP hasn't said (in this thread anyway) what her reserves situation actually is, nor whether she'd be fortifying or depleting it with her refinance.

She also hasn't said she doesn't have the money, necessarily, although its easy to make that assumption. She may be defending her reserves as "off limits" and THEN considering how to pay for her upgrades.

Donaldsg... which is the truth?

Cheers,
Dave Donhoff
Leverage Planner

The HELOC is a good option.

Most lenders will produce them for no closing costs (but a prepayment penalty exists on the back end...usually its 3 years).

If losing the job is that big of a concern and making the payments...typically there is a debt cancellation/payment protection insurance policy that can be purchased to help guard against that.