With mortgage interest rates at near-record lows, you may be tempted to refinance an existing mortgage. Does it make sense? It depends on your circumstances.
Strategy: Do the math first. Of course, taxes are a critical part of the equation. But also consider how much you’ll save with the lower interest rate and how long you expect to remain in the home.
Here’s the whole story: Generally, you can deduct mortgage interest expenses on up to $1 million of debt used to buy, build or substantially improve your principal residence (or one other home). This rule for “acquisition debt” also extends to interest paid on a refinanced mortgage. However, while “points” paid to initially acquire a home may be deducted in the year of the acquisition, you can’t currently write off any points on a refinanced loan. (Each point is equal to 1% of the borrowed amount.) Points on a refinancing must be amortized over the length of the term.
To determine whether you should refinance, you must find your “break-even point.” Take these five steps for a quick analysis:
1. Add up all your costs including points, application fees, attorney fees, loan origination fees, extra insurance, appraisals, inspections, recording and survey fees, title insurance, credit reports, etc.
2. Determine your monthly savings by subtracting your current payment from the amount due with a refinanced loan.
3. Multiply your monthly savings by your combined federal and state income tax rate.
4. Subtract this tax cost from your monthly savings to arrive at net monthly savings.
5. Divide your total cost by your net monthly savings to find the number of months it will take to break even (i.e., pay off the cost of refinancing).
Example: If you’re saving $250 a month with a refinanced loan and your total cost is $5,000, it will take 20 months to recoup the cost. If you plan on moving in about a year, it’s not worthwhile to refinance your mortgage. On the other hand, if you expect to stay put for several years, go ahead with the refinancing.
Be aware that certain hidden costs can put a damper on refinancing. For instance, your existing mortgage may contain a prepayment penalty clause. It could be as high as six months’ worth of interest on 80% of the balance (although the penalties generally are reduced over time). Also, if you opt for a no-point loan, you generally will pay a higher interest rate than you would with a loan requiring one or two points.
A number of online calculators can provide a detailed assessment based on specific facts. One such calculator is at www.bankrate.com/calculators/home-equity/refinance-calculator.aspx.
Tip: Shop around for the best deal. Your current lender may want to keep your business, so start there.
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