Has the Sun Set on Refinancing?
“Opportunities are like sunrises. If you wait too long, you miss them.”
William Arthur Ward
In November of 2012, the average interest rate for a traditional
30-year fixed rate loan was 3.31%, which is the lowest historical interest
rate on record dating back to 1971. Since November, and most notably
since June of 2013, 30-year interest rates have spiked to 4.74%.
Homeowners who were waiting for the right time to refinance may
be asking themselves if the opportunity has passed to take advantage
of such historically low refinancing. While it’s unlikely that interest
rates will return to their November 2012 lows in the near term, current
rates are still low from a historical standpoint and continue to provide
an excellent opportunity for homeowners in the right situation to
refinance.
Show Me the Money
When many homeowners think of refinancing, they tend to want to take advantage of the lowest possible interest rate to reduce the amount of their monthly payment and the amount of interest they will pay over the lifetime of the loan. While the interest rate is certainly a factor to consider when refinancing, what some people fail to consider are the tax ramifications, closing costs, discount point options and other variables that could inadvertently impact the homeowner’s overall financial plan. It is important to examine a wide range of considerations when evaluating refinancing options in the current environment.
What’s the Point?
Also referred to as “discount points,” points refer to percentage points that are added to the stated percentage yield of a loan. Homeowners can buy points at the outset of a home loan in order to lower the stated interest rate of a home mortgage loan. For example, one point is equal to 1% of the loan amount and typically drops the interest rate of the loan by .25 of a percentage point, depending on the lender. In general, points are negotiated and can either be paid up front before the loan in the form of pre-paid interest, or can be rolled into the overall cost of the loan. Depending upon a homeowner’s specific situation, either scenario could make sense. For example, consider a homeowner with a $1 million mortgage who is weighing his or her refinancing options. The homeowner considers an option of paying one point, or $10,000, up front to lock in a 30-year fixed jumbo interest rate of 4.25%, rather than the current jumbo rate of 4.5%. This may be appealing to a homeowner who has cash on hand to pay the point and likes the idea of receiving a lower interest rate over the lifetime of the mortgage. By paying the $10,000, the homeowner is able to reduce the monthly payments from $5,066 per month to $4,919 a month, for a monthly savings of $147. Over the course of the loan, this could save the homeowner close to $53,000.
But what if the homeowner had no intention of living in the house for the next 30 years? Would this strategy still make sense if the homeowner only planned to live in the house for another five to ten years? To answer this question, we’ll simply divide the amount of the point being paid ($10,000) by the monthly savings resulting from the lower interest rate ($147). This calculation tells us that the homeowner would need to live in the house for at least 68 months to realize the benefit of paying the $10,000 point up front. If the homeowner was planning on selling the home within five and a half years, he or she would want to avoid paying the point up front or may even reconsider refinancing as a strategy. Another consideration is the opportunity cost associated with paying the $10,000 point versus investing the funds. In the previous example, paying the $10,000 point reduced monthly payments by $147 a month and saved the homeowner $53,000 over the course of a 30-year loan. If the homeowner instead invested the $10,000 and earned an annual rate of 8% for 30 years, the $10,000 would increase to more than $100,600. While the investment option may carry more risk, it’s important to understand alternative options and how they could impact one’s overall financial plan.
It’s All Tax Deductible… Isn’t It?
One of the benefits of having a home mortgage is the ability to deduct payments paid on interest from taxes. But for homeowners interested in refinancing in order to access additional capital at a low cost, a common oversight is misunderstanding the rules on how much and what type of debt is actually tax deductible. Rules for mortgage interest deductions can be complicated and confusing, but are best understood by defining mortgage debt into two categories: home-acquisition debt and home-equity debt. Home-acquisition debt is defined as the amount borrowed to buy, build or substantially improve a first or second residence. For this type of debt, interest paid on mortgages up to $1 million ($500,000 if married filing separately) is deductible. Any excess amount borrowed for purposes other than buying, building or
substantially improving a first or second home is considered home-equity debt, and the interest paid is tax deductible up to $100,000 ($50,000 for married filing separately).
For an example of how a refinancing situation would work with both home-acquisition and home-equity debt, consider Mike and Molly Homeowner who are married and file their taxes jointly. Five years ago, Mike and Molly took a $600,000 mortgage to purchase a $750,000 home. Today, Mike and Molly owe $400,000 and their house is now worth $850,000. For their wedding anniversary, Mike and Molly decide to refinance their home for $650,000 and take advantage of low interest rates so Molly can build her dream kitchen for $125,000 and Mike can buy a $125,000 dream boat. Of the $650,000 refinanced, $525,000 would be considered home-acquisition debt and the interest would be tax deductible. This is because $400,000 of the debt is from the original amount owed on their home, and the $125,000 spent on the kitchen renovation would be considered a “substantial improvement” to the home, leaving the total amount of $525,000 below the $1 million dollar home-acquisition threshold. The $125,000 spent on Mike’s boat, however, would be considered home-equity debt because the funds were not used to buy, build or substantially improve a first or second home. Of the $125,000 used to buy the boat, interest paid on $100,000 would be tax deductible but interest paid on the remaining $25,000 would not qualify.
... Back to the Point
Regarding the tax deductibility of previously discussed mortgage interest points, how and when the points are deducted depends on the circumstances. For a homeowner who paid points as part of an original mortgage, the amount paid can be found on the 1098 statement from the mortgage lender, and the points can be deductible in the year the home was purchased if certain requirements are met. Those requirements might include how the points were computed and whether or not they are being paid toward the loan on a principal residence. It should be noted that, even if the seller paid the points as part of the home purchasing agreement, the buyer can claim the deduction on points that meet the requirements. Points paid during a mortgage refinance, however, would need to be paid over the amortized course of the loan. When the homeowner refinances, however, any remaining points left on an existing mortgage can generally be deducted in the same year the mortgage is refinanced.
An Alternative to Consider
The Alternative Minimum Tax (AMT) was originally created to prevent people with high incomes from using certain tax benefits to pay little to no tax. Over time, however, the Alternative Minimum Tax has been expanded to affect an increasing number of taxpayers and may have an impact on how to calculate deductible interest on a home mortgage refinance. For taxpayers who are subject to the Alternative Minimum Tax, only interest on mortgage debt used to buy, build or improve the home is tax deductible. This would be an important consideration for Mike Homeowner in the previous example, as the home equity interest paid on his boat would not be deductible if he is subject to the Alternative Minimum Tax.
Closing Thoughts
In addition to interest rate points and tax deduction implications, closing costs can also play an important factor for homeowners interested in refinancing. And, depending upon where you live, home refinancing may be more expensive than you realize.
When closing on a mortgage loan, it’s not uncommon to pay origination fees, legal fees, or more ambiguous “administrative costs.” These costs can add up quickly, and it’s important to ask your lender for clarification on closing costs as some of the fees may be negotiable. And while some closing costs, such as points, are tax deductible, not all closing cost can be deducted from taxes. A closing statement from the mortgage lender should give an itemized list of the closing costs, and a tax professional can assist in determining which costs can be deducted. For any closing costs that may be rolled into the refinancing of a mortgage, it’s important to include these in a breakeven analysis, as those costs could delay the date you recover the overall costs of refinancing.
It’s also important to understand fees or taxes that may be unique to your given state. States such as Kansas, New York and Oklahoma, for example, charge a “mortgage registration tax” as part of the mortgage closing process. These types of taxes tend to charge a tax per square foot of the home that’s being borrowed against. Costs such as the mortgage registration tax may be avoided if you are refinancing through the same lender, so it’s always important to ask which additional costs might be incurred when gathering quotes from different lenders.
Conclusion
For many people, their home represents one of their largest investments and decisions made regarding the financing of the home can have ramifications for many years to come. And while mortgage interest rates may continue to rise, the opportunity may still exist to refinance and dramatically improve your existing mortgage terms and overall financial plan. It’s important to note that any changes that an individual is considering regarding a refinancing strategy should be made after consulting a tax professional. Should you have any questions about refinancing or how it might affect your overall financial plan, please don’t hesitate to contact your wealth advisor at 1-866-346-7265 or visit our website at www.marinerwealthadvisors.com.
Mariner Wealth Advisors is an independent, national wealth advisory firm that provides unbiased financial advice focused on meeting client needs. Mariner’s expert wealth advisory teams help clients achieve and maintain financial peace of mind – preserving the wealth they have created and building a legacy for future generations of family and business leaders.
This document is for informational use only. Nothing in this publication is intended to constitute legal, tax, or investment advice. There is no guarantee that any claims made will come to pass. The information contained herein has been obtained from sources believed to be reliable, but Mariner Wealth Advisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.
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