Do the Math Before Picking a Refinance Mortgage

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Do the Math Before Picking a Refinance Mortgage

We are in a mortgage refinancing boom. Interest rates are lower than they have been in decades, and homeowners nationally are taking advantage of these rates.

The Internal Revenue Service recently issued a press release (IR-2002-114) reminding taxpayers that some, but not all, of their refinancing costs may be deductible.

According to the IRS, while points paid to obtain a refinance mortgage are generally not deductible in the year they are paid, "if part of the refinanced mortgage money was used to finance improvements to the home and if the taxpayer meets certain other requirements, the points associated with the home improvements may be fully deductible in the year the points were paid." The rest of the points on refinancing are deductible over the life of the loan, rather than in the year you get the loan, a big difference from home-purchase loans.

What does all this mean? Let's talk a bit about "points" and their role in the mortgage process.

When you apply for a mortgage, your lender will present you with a number of options. You can get a fixed 30-year or 15-year mortgage. You can also get an adjustable rate mortgage (ARM), where the interest stays fixed for a certain period of time (one, three or five years) and thereafter adjusts yearly based on a formula.

Generally, the shorter the term of the loan, the lower the interest rate will be. Thus, a one-year ARM should command a much lower rate than a fixed-rate 30-year loan. Prospective borrowers should understand that there is no free lunch. While the rate on a one-year ARM sounds very attractive, over the years it could command an interest rate considerably higher than the 30-year loan.

Mortgage lenders also will offer to reduce your mortgage interest rate if you pay points. A point is a fee equal to 1 percent of the principal amount of the loan ($ 2,500 on a $ 250,000 loan).

Each point normally has the effect of reducing the interest rate by one-eighth of a percentage point. Thus, you may be able to get a fixed 30-year loan at 6.375 with no points, but if you pay one point, your rate may be 6.25 percent.

Depending on your circumstances, this may be a lot of unnecessary money to pay to get a slightly lower loan rate.

Example: You want to borrow $ 250,000, and being conservative, you opt for a fixed 30-year mortgage. At 6.375 percent, your monthly mortgage (principal and interest) will be $ 1,559.68. If you pay one point (i.e., $ 2,500) and get a 6.25 percent loan, your monthly payment will be $ 1,539.30, or $ 20.38 less each month.

So you have spent $ 2,500 to save $ 20.38 per month. Is it worth it? It will take you a little more than 10 years before the interest rate savings start to kick in. Will you stay in the house for the next 10 years? Do you have something better to do with $ 2,500 than give it upfront to your mortgage lender?

And what about the tax benefits when you pay this point? If this is a loan to purchase a home, the point will be fully deductible in the year it is paid. But the amount you save depends on the tax bracket you're in. Even at the top bracket, 38.6 percent, you save just 38.6 percent of what you paid. A deduction is worth less to those in lower tax brackets and nothing to taxpayers who don't itemize deductions.

If you refinance and pay points, you can only deduct the points over the life of the loan. According to the IRS reminder: "For a refinanced mortgage, the interest deduction for points is determined by dividing the points paid by the number of payments to be made over the life of the loan. Usually, this information is available from lenders. Taxpayers may deduct points only for those payments made in the tax year. For example, a homeowner who paid $ 2,000 in points and who would make 360 payments on a 30-year mortgage could deduct $ 5.56 per monthly payment, or a total of $ 66.72 if he or she made 12 payments in one year."

However, if you refinance again, as a lot of homeowners have in recent years, the unused portion of the points from your previous loan should be fully deductible when you pay off that older mortgage.

If you are planning to refinance your existing mortgage, you must do your homework.

Comparison shop, not only with several lenders but also with several different kinds of loans. Get a rate sheet from the lenders you talk with so that you can sit down at home to analyze which loan is best suited for you.

Also, you should inquire as to whether there is a prepayment penalty associated with your existing loan, as well as with any future loan you obtain. Many lenders, recognizing that homeowners may refinance again within a short time, will attempt to impose a stiff prepayment penalty, especially on adjustable-rate mortgages. Clearly, the existence of such a penalty can be a significant deterrent to your refinancing plans.

There is some very helpful information on the IRS Web site. Go to the Web site www.irs.gov, and then Frequently Asked Questions (keyword: financing fees).

The IRS also has published several helpful documents that explain the subject in more detail. They are on the IRS Web site, or you can order them by calling 800-829-3676. These documents are Publication 936, "Home Mortgage Interest Deduction"; Publication 523, "Selling your Home"; Publication 527, "Residential Rental Property"; and Publication 530, "Tax Information for First-Time Homebuyers."