Interest rates for a 30-year mortgage loan are currently below four percent, continuing the opportunity to refinance at a historically low rate. When interest rates drop, you might wonder whether or not it makes any sense to refinance. Unfortunately, there are many different “rules of thumb” being directed to the public in answer the question, “When is the right time to refinance?”
One of these “rules of thumb” says that if your current mortgage loan is less than two years old, you should not refinance. Generally, this idea comes from the fact that you have just paid closing costs and when you refinance, there will be another set of closing costs.
Another common “rule” used to determine the feasibility of refinancing is that there should be at least a two percent spread between the old interest rate and the new refinance rate. The reasoning behind this rule is that at least a two percent difference in interest rates is usually needed in order to justify the expenses incurred when refinancing. In reality, refinancing your home mortgage could be done any time there is a significant savings in your monthly mortgage payment (or in your overall debt payments if you are consolidating other loans by refinancing) AND you plan to live in your home long enough to recover the expenses incurred with refinancing.
Let’s say that your current home mortgage is at a rate of five percent. A refinanced mortgage rate of 3.75 percent may currently be available to you. Before proceeding with refinancing your current mortgage you need to answer three questions in order to make a wise decision:
1 – What are the total costs involved in refinancing?
2 – How long do you foresee owning this home?
3 – How many more payments will the loan be extended by?
There will be a variety of costs incurred when refinancing a home mortgage. These include: a title policy to assure the lender that they have an enforceable deed of trust and loan on the property, an appraisal to determine your home’s market value, a loan origination fee, loan discount points, and a few other miscellaneous fees. Most title companies will offer a reduced title policy premium when the title insurance is re-issued for an owner within two years of the original title policy issue. This offer is possible because there is less exposure to the title company over such a short period of time.
Most homeowners upon purchasing a home find out that any loan discount points paid are deductible as interest by the buyer in the year that they are paid. What may not be generally known is that discount points paid to refinance a home are not fully deductible in the year they are paid. These must be prorated or spread out over the life of the mortgage. For example, if a homeowner paid $3,000 in loan discount points to refinance their home mortgage at a lower rate, they could potentially deduct $100 in interest each year for a 30-year mortgage. This would mean a $28/year tax savings if in the 28 percent tax bracket or $15/year tax savings if in the 15 percent tax bracket. The downside is that the homeowner had to pay $3,000 either in cash or by adding this amount to the mortgage. If possible, it is generally recommended that homeowners refinance with a “par value” loan, or in other words, that they refinance at a rate which does not require the payment of any loan discount points. This keeps the out of pocket expenses of refinancing at a minimum even though the interest rate may be slightly higher.
It is necessary to understand two terms in order to determine whether the interest payments on a home mortgage are fully deductible: “acquisition debt” and “home equity debt”. Acquisition debt is the amount of money borrowed in order to buy, build, or make capital improvements to a principal or second home. The deductibility limit for acquisition debt is $1,000,000 for the combination of a first and second home. As the principal is paid down on this mortgage, the acquisition debt is reduced. Home equity debt has a deductibility limit of $100,000 above the current acquisition costs for both the first and second homes. Money pulled out of a home’s equity can be used for any purpose including home improvements, education, and medical expenses, business expenses, or restructuring and paying off other debts. When a homeowner refinances a mortgage, the acquisition debt does not increase. For example, if a person originally borrowed $175,000 to purchase their home and the current unpaid balance is now
$150,000, the acquisition debt is now $150,000. By refinancing only the $150,000 balance the interest payments will still be deductible. Assuming the market value of the home will allow it, the homeowner could borrow up to $250,000 and still have all of the interest payments be deductible. $150,000 of the new loan would still be considered acquisition debt and the additional $100,000 would be considered home equity debt. An important thing for homeowners to be aware of is that all of the interest payments on a principal or second home mortgage may not be tax deductible even though a mortgage company may be willing to make a certain loan amount. The limit restrictions for “acquisition” and “home equity” debt must be taken into consideration and your tax advisor should be consulted for current tax rules.
Due to the competitive nature of the home mortgage business, some lenders will offer “Low” or “No Closing Costs” loans. These types of loans will typically have a slightly higher interest rate. It is important to find out if the lender is actually not charging any closing costs or if these costs are being added to the refinanced mortgage amount. Adding closing costs to the mortgage can hide potentially high loan fees that increase the overall costs of the mortgage, even though the out of pocket expenses are kept low.
When refinancing, the payment can drop for reasons other than interest rate. One is that if the old loan was amortized, the principal is being paid down a bit each month. When the refinance loan is done, the balance will be lower than the original, unless cash is pulled out or if the original loan was interest only. Second, by refinancing, the loan repayment process starts over at 30 years to go. Therefore, much of the monthly savings is tacked on to the end of the loan. Some people will argue the “time value of money”. In other words, those dollars added on the end are worth much less than dollars today, hence the argument, “don’t pay your mortgage off early”.
In summary: First, consider refinancing whenever it creates a significant monthly savings and you can recover the expenses of refinancing during the time you own the home. Second, consider a “par value” loan to keep closing costs at a minimum and be aware that loan points paid when refinancing are not fully deductible as interest in the first year. Finally, consult your mortgage loan professional and tax advisor to discuss your specific details.
By Duane Duggan. Duane has been a Realtor for RE/MAX of Boulder in Colorado since 1982 and has facilitated over 2,500 transactions over his career, the vast majority from repeat and referred clients. He has been awarded two of the highest honors bestowed by RE/MAX International: The Lifetime Achievement Award and the Circle of Legends Award. Living the life of a Realtor and being immersed in real estate led to the inception of his book, Realtor for Life. For questions, e-mail DuaneDuggan@boulderco.com, call 303.441.5611 or visit boulderco.com.