Dear Dr. Don,

I am going through a divorce. My husband has chosen to leave the home, and I will keep it for the children and me to live in. In the settlement agreement, I have to give him $20,000 to buy out his interest in the home. He wants cash, not like funds from a pension, etc.

I will have to refinance the mortgage to remove his financial responsibility. In doing so, I will go from a mortgage with 7% interest to a lower-rate mortgage. The current mortgage is $108,000. A local Realtor who has sold properties in my development has estimated the value of the home at $156,000 as the likely purchase price in the current market.

My question is this: "What is the best way to obtain $20,000 to pay my soon-to-be ex-husband?"

There seems to be many options: use cash-out refinancing, get a home equity loan, borrow from a 401(k). I plan to repay it in four years or less, no matter where I get the funds from.

-- Rita Reclaims

Dear Rita,

As you point out, you will have to refinance in order for your ex-husband not to be financially responsible for the mortgage debt. Although it's worth a phone call to discuss it with your lender, there's just no upside for the current lender to agree to take your ex-husband off the note.

If you live in a community property state, I'd recommend consulting with a real estate attorney if you're trying to finance the home prior to your divorce being finalized. That's because debts undertaken while married in a community property state are typically considered joint debts, even if only one spouse is listed on the loan. It would be a shame to jump through all these financial hoops only to find yourself back where you started -- needing to finance a mortgage. A real estate attorney will be able to tell you if it's possible to finance solely in your name in a community property state before you complete your divorce decree. The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. Couples in Alaska can elect community property status.

Lenders have gotten a little gun-shy about cash-out refinancing loans. While you have a healthy equity position in the home, an 80% loan-to-value, or LTV, first mortgage would come in at $124,800, and that doesn't free up enough cash to buy him out. At higher loan-to-value ratios, your monthly payment is likely to include a private mortgage insurance, or PMI, premium. You'll have to decide whether to keep the LTV at 80% and fund the closing costs and the balance of the buyout from another source like a home equity line of credit, or HELOC; a loan from your 401(k) plan; or to pay the PMI, which I estimate to be about $40 per month.

The table below lays out the cash-out refinance.

Cash-out refinance
Estimated appraised value: $156,000.00
Current loan balance: $(108,000.00)
Buyout payment: $(20,000.00)
Loan amount: $128,000.00
Loan-to-value: 82.05%
 
New loan
Loan amount: $128,000.00
Interest rate: 4.77%
Loan term (months): 360
Monthly mortgage payment: $669.25
Estimated PMI: $40.53

I like the approach of paying for most of the buyout with cash-out refinancing, but keeping the loan at 80% loan to value rather than paying PMI. Then, you can either take out a loan against your 401(k) plan or use a HELOC to pay the balance of the buyout. You have to get a new mortgage anyway, so why not use a cash-out refinance as your funding source for most of the buyout payment?

While you're working on this, I'd like you to read the Federal Trade Commission's publication on credit and divorce and Experian's Web page on the same topic.

The information will help you manage your credit history as you transition out of your marriage.