With home mortgage rates at historic lows, it may be appropriate for you to consider refinancing your current mortgage. However, refinancing may not always be the greatest idea, even though mortgage rates are low, and even when your friends, relatives, and coworkers are bragging about the low interest rates they got with their refinance. This is because a number of issues must be considered when refinancing.
Cost to Refinance – Refinancing can be costly, considering you might have to pay for title insurance, points, and other closing costs that easily can lessen the benefits of a lower interest rate and generally aren’t tax-deductible. However, many lenders are offering no-cost refinancing, so you need to compare lenders carefully. Some may be offering no-cost loans, but the interest rate may be higher, or vice versa.
Interest Rates – One of the primary reasons to refinance is to secure a lower interest rate for your home loan. Whether refinancing is a good idea depends on how much you can reduce your interest rate and resulting mortgage payments. Some recommend reducing your interest rate by at least two percentage points, while others contend that as little as a one-point savings is enough of an incentive to refinance. However, you must also consider the costs of refinancing and the tax implications discussed later.
Credit Score – Some homeowners are concerned that refinancing will affect their credit rating adversely. Of course, all lenders will check your credit score, and adding new debt naturally will cause your credit score to dip. But because refinancing replaces an existing loan with another of roughly the same amount, its impact on your credit score is minimal. However, increasing the amount of the loan will have a negative impact on your credit score. Additionally, taking out cash and increasing the loan amount will have negative tax effects, as discussed later.
Borrowing Additional Cash – Some lenders are even hyping taking out additional cash when refinancing. They suggest vacations, retail purchases, and other discretionary uses. Many borrowers have already forgotten the hard lessons of 2004 through 2008, when home prices took a severe drop in value and those who treated their home equity like a piggy bank found themselves owing more on their home than it was worth. Sound financial planning dictates paying off one’s home as quickly as possible and resisting borrowing against its equity.
If you are tempted to take out additional cash, you should also be aware that interest on equity debt is not tax-deductible. This means if the replacement loan is greater than the amortized balance of your original loan, then the interest attributable to the equity debt (the cash out) will not be deductible.
Example: Your original debt to purchase your home (the acquisition debt) some years ago was $300,000. You’ve paid off $100,000 of the original debt, leaving a loan balance of $200,000. You refinance it for $300,000, taking $100,000 in cash out. So, the new loan is 2/3 acquisition debt and 1/3 equity debt. Thus, any interest paid on the refinanced loan will be only 66.67% deductible since the loan is 1/3 equity debt.
However, if the $100,000 in the example was used to make substantial home improvements, then the additional $100,000 of debt would be treated as acquisition debt, and the interest on the entire loan would be deductible, subject to the loan-term limits discussed next later.
Mortgage Limit – As modified in 2018 the tax law currently only allows an interest deduction on home acquisition loans up to $750,000. But the law does grandfather prior loans (those taken out before December 16, 2017) based on prior law which allowed home acquisition debt of up to $1 million. So, if you are refinancing your home loan to pay for a substantial home improvement, then $750,000 becomes the limit.
Example #1: Suppose your grandfathered mortgage balance is $800,000 and you refinance to pay for a kitchen remodel. Although you can still deduct interest on the portion of the loan attributable to the grandfathered portion of the refinanced loan, the interest on the portion of the remaining refinanced loan balance will not be deductible.
Example #2: If your existing mortgage is less than $750,000 any amount borrowed up to the $750,000 limit and used to pay for substantial home improvements would be treated as home acquisition debt, and the interest on that portion of the loan would be deductible as home mortgage interest if you itemize your deductions.
Loan Term – Mortgages are available for various terms, and the most common for first-time homeowners is 30 years. However, many of the current loans offering the best interest rates are 15-year loans. So, depending upon your circumstances, the shorter-term loan may not reduce your mortgage payments but will instead pay off your mortgage sooner.
The Tax Cuts & Jobs Act (TCJA), which became effective in 2018, included a restriction to extending the term of the original acquisition debt. This is best described by example:
Example #3: A taxpayer’s original loan to purchase a home was a 20-year loan taken out on January 1, 2010. Thus, it would normally be paid off on January 1, 2030. If the taxpayer were to refinance the amortized balance of the loan with a 15-year loan on July 1, 2021, that loan normally would be paid off on July 1, 2036, thus extending the refinanced loan term by 6.5 years. However, under current law, the interest on the refinanced loan will only be deductible for the term of the original acquisition debt, and the interest on the refinanced loan would cease to be deductible after January 1, 2030, meaning that the interest on the loan would not be deductible for the remaining 6.5 years of the loan.
State Treatment – Some states, including California, have not conformed to the home mortgage debt interest and loan term changes made by the federal tax reform. In these states, for Example 1, above, the deduction on the state return would include all of the interest paid during the year because the loan amount is less than the $1 million limit, and in Example 3, the interest would continue to be deductible as home mortgage interest until the refinanced loan is paid off in 2036.
Itemizing Deductions – Qualified home mortgage interest is deductible only if you itemize your deductions rather than claim the standard deduction. For a married couple filing a joint return, their 2021 standard deduction will be $25,100. The standard deduction for those filing single or head of household is $12,550 or $18,800, respectively. These amounts are slightly more for those who are age 65 or older and/or blind. For most people, their itemized deductions will consist of medical expenses exceeding 7.5% of income, charitable contributions, state and local income and property taxes (maximum $10,000), and home mortgage interest. If your itemized deductions have been just over your standard deduction amount, after refinancing at a lower interest rate, it’s possible that your total itemized deductions could be less than your standard deduction amount because you will be paying less interest. This means you would not get any tax benefit on your federal return from the mortgage interest you pay. In this case, you would want to be aware of the strategy of bunching deductions, which then could allow you to itemize one year and use the standard deduction the next year.
As you can see, there is a lot to consider when contemplating a refinance. If you need assistance in making your decision, please call for an appointment.