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Contemplating Refinancing Your Home Mortgage? Things You Should Consider
Article Highlights:
- Is It Appropriate to Refinance Your Home Loan?
- Refinance Costs
- Interest Rates
- Credit Score
- Borrowing Additional Cash
- Mortgage Limit
- Loan Term
- State Treatment
- Itemizing Deductions
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.
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 #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.
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:
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.
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