Refinancing your home mortgage: consider all the factors.
In an address to the nation last summer, the President illustrated how a middle class family with a $100,000, 10% mortgage could put an additional $175 in their pocket each month by refinancing the mortgage at 7.5% (August 3, 1993). Comparable savings could be realized today since interest rates on 30-year fixed mortgages remain near the record lows set last summer. Currently, the Federal Home Loan Mortgage Corporation reports the yield on a 30-year mortgage at 7.49% (March 2, 1994). This is up only slightly from last summer when interest rates dipped below 7% for the first time in 25 years. Adjustable rate mortgages have also set record lows, falling to 3.875% (March 2, 1994).
The President's reasoning is sound: refinancing at the lower interest rates will reduce monthly mortgage payments and increase the amount of discretionary income in consumers' pockets. The hope is that the increase in cash flow will flow through to other sectors of the economy and stimulate borrowing and spending on other big-ticket items. Lower interest rates translate into more consumer, business and college loans. Higher retail spending on refrigerators, cars and electronics [TABULAR DATA FOR TABLE 1 OMITTED] should lead to faster economic growth.
To illustrate further what refinancing means to homeowners, consider a $100,000, 10% fixed rate 30-year mortgage. The outstanding mortgage balance is refinanced after four years with another 30-year mortgage at 7.04%. Both the original and [TABULAR DATA FOR TABLE 2 OMITTED] the new monthly payments (principal and interest) are shown in Table 1. Refinancing reduces the monthly payment by over $227. This is great news for the homeowner and, hopefully, the economy.
There are, however, some unintended consequences of refinancing. Also, the financial community may ignore some factors that should be considered when selecting the best refinancing strategy to follow. Some unanswered questions include:
* What about the homeowner's additional tax liability due on April 15th because of the lower interest deduction on Schedule A?
* What about underpayment penalties if taxpayers do not satisfy the safe-harbor rules?
* What about homeowners who can refinance over 15 years?
* What are homeowners doing with the extra money?
* When to refinance? What is the best refinancing strategy?
Home mortgage interest is one of the few itemized deductions left for most American taxpayers and the benefit will decrease significantly because of the refinancing decision. Continuing with the earlier example, the bottom portion of Table 1 shows the decrease in the interest deduction over the next four years. If the taxpayer is in the 28% tax bracket, refinancing results in an additional tax liability of $3,194 over the four-year period. While this is still a good deal for the homeowner, the potential benefit to the economy is greatly reduced. Part of the savings will go directly to the Federal government as higher taxes.
For taxpayers in the new higher tax brackets, the savings from refinancing will be slashed even further. Recent legislation created a 36% tax bracket and raised the top bracket to 39.6% for individuals with earned income above $250,000. For example, taxpayers in the 36% tax bracket would pay an additional tax of $4,106 over the first four years, leaving a savings of $6,791.
Taxpayers also may incur underpayment penalties if their estimated payments and withholdings do not satisfy the safe-harbor rules. Beginning in 1994, the rules have been greatly simplified. To avoid the underpayment penalties, taxpayers must pay:
* at least 90% of their current year's tax liability, or
* 100% of last year's tax liability.
In order to meet one of the safe-harbor rules, taxpayers may need to adjust their withholdings, or their estimated tax payments, in the year that they refinance their mortgage. Otherwise, they may be subject to a 7% penalty based on the amount of the underpayment and the number of days from the due date to the date the tax was paid.
Refinancing Over 15 Years
Now many homeowners can refinance over 15 years with little increase in their monthly payments. Depending on the spread between interest rates, some may even decrease their monthly payments while paying off their mortgage quicker - for example, mortgages more than 3-4 years old issued when interest rates hovered around 11%. Homeowners who missed out in the rush to refinance in the fall of 1992 when rates dipped down in the mid-8% range may now get a better deal. Refinancing may now be attractive to baby boomers who want to pay off their home mortgages before retirement. Some mortgage companies report that nearly half their refinancing activity involves 15-year mortgages. Using the same facts as the earlier example, Table 2 shows the new payments when refinancing over 15 years. Without changing the monthly mortgage payment, the taxpayer could pay off their mortgage in half the time.
Again, there is an increase in the tax liability because of the decrease in the interest deduction. The bottom portion of Table 2 shows how taxes will rise by $3,655 over the four-year period, leaving a net decrease in monthly cash flows. Taxpayers in the 36% tax bracket will pay additional taxes of $4,699 because of the decrease in the interest deduction of $13,053.
Alternative Uses for the Savings
Whether people decide to refinance over 30 years or 15 years, not all the savings are finding their way into the economy. There is some evidence that suggests that Americans' propensity to spend, not save, may be slowly changing. Refinancing over 15 years is a type of forced savings plan for people that are not disciplined savers. They can pay off their debts faster and build equity in their homes quicker. Others have stuck with a 30 year mortgage and increased their savings because of a fear of losing their jobs and uncertainty about their future. Others may purchase larger, more expensive homes as they discover they can get more home for their money.
The Best Refinancing Strategy?
The traditional rule of thumb to decide whether it is worth refinancing and to select the best plan involved dividing the total closing costs by the monthly savings. The result is the number of months that it would take to recoup the closing costs. If the homeowner plans to stay in the home longer than the breakeven point, refinancing benefits the homeowner. This may be too simplistic given the larger tax consequences of refinancing, since it underestimates the payback period. A better measure considers the after-tax savings.
Consider the 30-year mortgage with two points and closing costs totaling $3,500 that generated a savings of $227 per month. As a rule of thumb, most lenders would claim that the breakeven point, where the benefit from refinancing exceeds the closing costs, is 15 months. If one also considers the future tax consequences of the lower interest deduction, it would take a taxpayer in the 28% tax bracket 22 months to recover closing costs. The breakeven point would be even further away for taxpayers in the new higher tax brackets or for homeowners refinancing with a smaller spread between interest rates. By ignoring the tax benefit generated by the old, higher interest rate loan, the breakeven point is underestimated.
Even the long-term advantages of refinancing tend to be obscured in most discussions by mortgage brokers, economists and financial planners. Usually they do not consider the payments already made on the mortgage that decrease the remaining term of the mortgage. The real savings should be computed by comparing the payments remaining on the existing mortgage with the total payments over the term of the new mortgage. Although refinancing with another 30-year mortgage will reduce the amount of the monthly payments, it will extend the payment period. Continuing with the 30-year refinancing example above, Table 3 shows that the actual savings from refinancing over 30 years are $39,610 [TABULAR DATA FOR TABLE 3 OMITTED] before taxes. After taxes, the savings amount to only $951 per year over the 30-year life of the new mortgage. While the savings from refinancing appear to be larger, there are fewer payments remaining on the original mortgage (only 312 payments remain on the old mortgage). Most comparisons look only at the monthly savings between the payments, ignoring all the payments made on the existing mortgage that have shortened the term.
Table 3 shows that significant savings from refinancing occur only when the homeowner slashes the term of their mortgage. Then they can own their home much quicker and save almost $83,000 (after tax). A more complete analysis of when to refinance should consider the tax effects of lower mortgage interest deductions, the spread between interest rates and the number of payments already made on the original mortgage. Yet even this analysis may be incomplete because it fails to consider the time value of money.
To make the two options comparable, however, the after-tax savings must be discounted to the present. Expanding on the previous examples, an 8% discount rate is used to determine the present value of the future cash flows, which represents the rate of return specified by the Internal Revenue Service for earnings computations. Tables 4 and 5 present the present value of the after-tax savings at the end of each year over the term of the mortgage. The last column in each table presents the total benefit to the homeowner from refinancing. There are, however, two components to the calculation:
* the cumulative present value of the after-tax cash flow difference, and
* the present value of the difference [TABULAR DATA FOR TABLE 4 OMITTED] [TABULAR DATA FOR TABLE 5 OMITTED] between loan balances (the loan payout difference).
The first component is computed by taking the cash savings between the old payment and the new payment and subtracting the tax savings generated by the old loan. Recall that the new loan will result in a lower interest deduction and higher taxes, which reduce the cash savings. The second component is the difference between the old loan balance and the new loan balance. For example, refinancing over 15 years gives the homeowner greater equity in the property. The faster equity buildup will leave the homeowner with more cash in hand if the home is sold prior to the scheduled loan payoff date. The two components are combined to see if it is worthwhile for the homeowner to refinance.
A comparison of the benefits from refinancing in Tables 4 and 5 show that while both strategies clearly benefit the homeowner, the 15-year mortgage has a slightly lower present value. While the 15-year refinancing plan provides faster equity buildup, there are several drawbacks that may make the plan less attractive. First, the 15-year mortgage requires greater cash outflows in the early years because of the lower interest deduction. Second, much of the savings from refinancing over 15 years occur in the later years when the present value of a dollar is much less.
This approach also can be used to determine the breakeven point from refinancing. For example, if the homeowner incurs closing costs of $3,500, the breakeven point from a 30-year refinancing plan is near the end of the second year.
Taxpayers must be more aware of the tax consequences of their decision to refinance their home mortgage. Also, when deciding when to refinance and what would be the best strategy, homeowners must consider more factors than are normally suggested by the financial press. The analysis should consider the spread between interest rates, the tax effects of the home mortgage interest deduction, the remaining term of the old mortgage and the timing of the savings. Often homeowners overlook the payments that have been made on the existing mortgage that have shortened the term of the old mortgage. Because of differences in when the savings are realized, present value concepts also should be used to help determine the best refinancing strategy.
Charles Kelliher, CPA, PhD, is an assistant professor of accounting at the University of Central Florida in Orlando.
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|Author:||Kelliher, Charles F.|
|Publication:||The National Public Accountant|
|Date:||Dec 1, 1995|
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