Broker Check

The Refnancing Decision

| November 01, 2015
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Debt Management

Are you considering refinancing your home mortgage?  There are some situations in which refinancing a home mortgage makes sense. These include significantly reducing your old, higher interest rate to take advantage of historically low rates today, switching from an unpredictable variable rate to fixed rate, or to change the term of your loan and pay it off quicker.

Refinancing can be financially beneficial, but the costs associated with refinancing must be balanced against any potential savings.

A general rule of thumb is that refinancing a fixed mortgage makes sense when the interest rate on the current mortgage is at least two percentage points higher than the prevailing market rates. In some instances, however, a very small percentage point spread may justify refinancing if other factors are present.  These factors include things such as closing costs, length of ownership and your tax bracket.

The real cost of refinancing is the closing costs.  These costs include potential prepayment penalties on the old loan, points and fees on the new loan and attorney fees.  These can typically  total 3% to 4% of the loan amount and are paid upon closing.   When weighing the refinance decision, analyze how many months it will take to make up the costs with the savings from the new loan.  This is referred to as the payback period or the break-even point.  In other words, it is the minimum length of time the borrower must hold the new mortgage to make the refinancing pay.

You should also consider your projected length of ownership.  The longer you plan to stay in the home, the smaller the spread between the old loan and the new loan can be because you can spread the closing costs over the life of the loan.  Alternatively, even with lower payments from a new loan, if the projected time in the house is short, the closing costs may consume any savings.  The projected term of loan will also be a factor in determining if you go for a variable or fixed-rate loan.   The initially lower rate on a variable loan may be more advantageous in the short term, but comes with potential interest rate risk which should be considered.

With respect to taxes, in general, the higher your income tax bracket, the larger you interest payment deductions.  Consider how the lower interest payments from a refinanced loan will impact your taxable income.   It is also important to remember that loan amounts in excess of acquisition debt on a first and second residence (up to $1 million), plus $100,000 in home equity loans is not deductible. Acquisition debts refers to loans incurred to buy, construct or substantially improve a qualified residence.  If your new loan falls under these limits and the interest payments are tax deductible, it may make sense to consider paying off other consumer debt first on which interest payments are no longer deductible.

Another factor to consider is the impact of lost interest.  This is the interest you would have earned on upfront and monthly payments if you had saved the monies at your after-tax savings rate.

Lastly, you should consider the effects of mortgage insurance.  If your loan is greater than 80% of the home value, you may be paying premiums for mortgage insurance.  Refinancing to reduce your loan value to 80% or less can eliminate this insurance premium and substantially reduce your payments.

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