Mortgage Refinance or Second Mortgage?

In the summer blockbuster Inception, one hopeful decision changes everything for dream extractor Dom Cobb. There’s no arguing that making a short-sighted choice exposes you to unintended consequences — not only in dreamscapes, but also in the concrete world of home mortgages.

When you need cash and you have home equity, the most obvious source of liquidity is your home. Generally speaking, you have two options: refinance your existing mortgage loan for a larger amount, or tap your equity to take out a second mortgage. For most households, one of these will clearly be the better choice. Consider the following factors to determine your best strategy.  

Pay-off timing

A standard mortgage refinance resets your pay-off clock for 30 years. If you don’t refinance, when will your home be paid off? Do you want to push that date out by another five, six, or seven years? You can avoid this reset by using a second mortgage for the money you need, and leaving your first mortgage intact. Or, if you can afford the higher payments, refinance your first mortgage into a 15-year loan.

Total interest costs
   
The total amount of interest you end up paying on your mortgage is derived from your interest rate and the length of time you’re borrowing the money. If you reset your pay-off clock, your total interest costs may be higher, unless the new interest rate is substantially lower. Compare the total interest costs of your options using a mortgage calculator so there are no surprises.

Monthly payment

Is the monthly payment amount your primary concern? With a second mortgage, you add an additional payment to your existing debt load. It’s possible to refinance your first mortgage for a higher amount, and end up with a lower monthly payment, if interest rates are substantially lower than the rate you’re currently paying. While this might seem ideal, it usually requires you to reset your pay-off clock, and you may incur higher total interest costs.

Asset and liability matching

The life of the asset you’re purchasing should match the term of the related liability. Cars are typically financed for no longer than five years — because that’s how long they last. If you have a longer maturity, you’d still be making payments on your old car in five years when it’s time to buy a new one.

What will you purchase with the proceeds from the new loan? Long-term investments, like college tuition or a home remodel, may be suitable for a 30-year mortgage refinance. If you plan to buy something that needs to be replaced every few years, consider getting a shorter-term second mortgage.

Ultimately, you have to choose carefully between a mortgage refinance and a second mortgage. Or else, as in Inception, you may have difficulty waking up from a bad dream.