By Ken Berry
Mortgage rates throughout the country have reached historic lows. The going rate for a conventional, thirty-year mortgage has dipped below 4.5 percent, and the rates for fifteen-year mortgages are even lower. Given the current interest rate environment, many of your clients will be tempted to refinance their existing mortgages.
Caution: Despite the rock-bottom rates, refinancing isn't always advisable. Help your clients by doing a thorough analysis, taking into account the tax implications, the monthly savings available with a lower interest rate, and the length of the time the client expects to remain in the home. The key is to find the break-even point, which is the number of months your client will need to live in the home after refinancing in order to recover the costs of refinancing.
Let's start with the tax basics. Generally, a taxpayer can deduct the mortgage interest paid on acquisition debt of up to $1 million used to buy, build, or substantially improve a principal residence or one other home, such as a vacation home. This includes acquisition debt paid on a refinanced mortgage. However, if the taxpayer incurs points on the refinancing, the points must be amortized over the length of the loan. Each point is equal to 1 percent of the mortgage amount.
Even if the taxpayer can deduct all of the mortgage interest, a lower interest rate will eventually result in smaller interest deductions. This means that a client might actually save less over the term of the loan than he or she might think.
Of course, online calculators can do the grunt work for you, but you can also use a quick "back-of-the-envelope" formula to estimate the break-even point for a client. Follow these five steps:
- Add up all refinancing expenses, including points, application fees, attorney fees, loan origination fees, additional insurance, appraisals, inspections, recording and survey fees, title insurance, credit reports, and so on.
- Figure out the monthly savings by subtracting the client's current monthly payment from the amount that will be due with a refinanced loan.
- Multiply the monthly savings by the client's combined federal and state income tax rate.
- Subtract the tax cost from the monthly savings to arrive at the net savings.
- Divide the total cost by the net savings to determine the number of months it will take to pay off the refinancing expenses. This is the break-even point; in other words, any future savings are gravy.
Example: The Smiths will save $500 a month by refinancing, and the total cost is $8,000. It will take the couple sixteen months to recoup the cost of refinancing. If the Smiths plan on moving in about a year, it's not worthwhile for them to refinance. Conversely, if they expect to stay in the home for two years or more, refinancing probably makes sense.
Additional factors also can come into play. For instance, if the existing mortgage contains a prepayment penalty clause, it will effectively increase the length of time it will take for the client to break even. Also, if a client chooses a mortgage that does not require points, the rate likely will be slightly higher than the advertised rate.
Best approach: Steer your clients in the right direction by crunching the numbers for them. If refinancing is a viable option, caution clients against fly-by-night operations that are offering "sweetheart" deals that are too good to be true. Advise them to use a reputable lender with a proven track record.