When interest rates decline, you might question whether refinancing is worthwhile. Unfortunately, numerous “rules of thumb” circulate to address the question, “When is the right time to refinance?”
One such “rule of thumb” suggests that if your mortgage is less than two years old, refinancing may not be advisable. This advice typically stems from the fact that you’ve recently paid closing costs on your current loan, and refinancing would entail incurring another set of closing costs.
Another frequently cited “rule” for evaluating whether refinancing makes sense is that there should be a minimum 2% difference between your old interest rate and the new refinance rate. This guideline is based on the idea that a 2% spread is typically necessary to offset the costs associated with refinancing. However, in practice, refinancing can be beneficial whenever it leads to substantial savings on your monthly mortgage payments (or overall debt payments if you’re consolidating other loans) and you intend to stay in your home long enough to recoup the refinancing expenses.
Suppose your current mortgage rate is 7.5%, and you’re offered a refinanced rate of 5.5%. Before moving forward with refinancing, it’s important to answer three key questions to ensure you make a well-informed decision:
- What are the total costs involved in refinancing?
- How long do you foresee owning this home?
- How many more payments will the loan be extended by?
There will be a variety of costs incurred when refinancing a home mortgage, including 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% tax bracket or a $15/year tax savings if in the 15% 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 that 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 limit restrictions for “acquisition” and “home equity” debt must be taken into consideration and your tax advisor should be consulted for current tax rules.
When refinancing, the payment can drop for reasons other than the interest rate. One is that if the old loan was amortized, the principal would be 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 today’s mortgage market, some lenders are offering mortgage products with whatever term you desire or a recast of the current loan.
In summary:
- Consider refinancing whenever it creates a significant monthly savings and you can recover the expenses of refinancing during the time you own the home.
- 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.
- Consult your mortgage loan professional and tax advisor to discuss your specific details.
Duane graduated with a business degree and a major in real estate from the University of Colorado in 1978. He has been a Realtor® in Boulder since that time. He joined RE/MAX of Boulder in 1982 and has facilitated over 2,500 transactions over his career. 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 BoulderPropertyNetwork.com.