Refinancing, is it time yet? An oft-quoted rule of thumb is that a borrower should consider refinancing if interest rates fall more than 2 percent below the original rate. This rule of thumb is really too simplistic to have much meaning. The question really involves comparing the after-tax savings in the monthly payment to the closing costs of the refinancing.
There are numerous costs in any mortgage financing. These may include loan origination fees, application fees, credit checks, appraisal fees, attorney fees, title insurance, transfer taxes and others.
The lender may also charge discount "points" that amount to prepaid interest. These points can run 1 to 3 percent of the loan.
Points, unlike loan origination fees, are deductible as interest. However, the points that are paid upon acquisition of a home are deductible in a lump sum. Points on refinancing are deductible over the life of the new loan. The total closing costs on a refinancing can easily run 4 to 5 percent of the loan amount, although you may be able to get a break by careful shopping or dealing with your current lender.
To really compare apples to apples, you should compare the after-tax cost of the new mortgage with the old.
Since mortgage interest is deductible, the after-tax cost of the loan equals the principal and interest payment after deducting the taxes saved attributable to the deduction.
The computation is fairly simple in most cases. The number crunching gets a little more complex if the change in mortgage-interest deductions causes you to cross over into another bracket, but the theory is the same. State taxes should also be considered if your state allows a deduction for home mortgage interest.
For example, Tim originally borrowed $103,000 for 30 years at 9.5 percent four years ago to buy his home. Today he can refinance his home for 30 years at 5.5 percent at a total cost of 4 percent of the loan amount. Tim's loan balance today is $99,982. He is in the 25 percent tax bracket. The cost to Tim to refinance is $3,999 (assume no deductible points). Tim decides to refinance a total of $103,981 ($99,982 plus $3,999). His current monthly mortgage payment is about $866 of which about $792 is interest. That makes his after-tax payment about $668 (866 minus 792 times 25 percent). His new mortgage payment will be about $590, of which roughly $477 will be interest, for an after-tax cost of $471. Tim will be saving, after tax, about $197 per month. At that rate, it will take about 20 months (3,999/197) before he breaks even. If Tim plans to stay in the house longer than that, then refinancing makes sense.
Of course, this brief article is no substitute for a careful consideration of all of the advantages and disadvantages of this matter in light of your unique personal circumstances.
Before implementing any significant tax or financial planning strategy, contact your financial planner, attorney or tax advisor as appropriate.
Marc P. Tomberg is branch manager at Raymond James Financial Services. His office is located in Ryanwood Square at 2140 58th Ave, Vero Beach. He may be reached by phone at (772) 778-4399.