Interest rates may be falling slowly, but they are falling, as the Federal Reserve seeks to ease credit. As of this writing, the average rate on a 30-year fixed-rate mortgage is below 6%, according to Freddie Mac.
As recently as July 2007, the average rate was 6.7%. Therefore, you might want to refinance your mortgage to save on interest expenses.
Payoff for good behavior: Today, lenders are penalizing borrowers with subpar credit scores by making them pay higher interest rates. Conversely, borrowers with good scores pay lower rates.
Example: According to Fair Isaac, developer of the FICO credit score used by most lenders, someone with a 680 credit score might pay 6.063% for a 30-year loan. With a 720 score (around the national median), you would likely pay 5.8%, and 5.6% with a superior 760 score.
You can purchase your credit score at myFICO.com (www.myfico.com).
Bottom line: If your credit score has improved since you took out your mortgage, perhaps because late mortgage or late credit card payments from prior years no longer count in your score, you might be able to trim your costs by refinancing now.
If you’re refinancing your mortgage, knowing the tax rules can help you make the most of available tax deductions.
Strategy: To be sure that all of your interest will be deductible, refinance with a dollar-for-dollar replacement loan.
Example: Your current loan balance is $200,000 on a 6.7% loan. If you refinance with a $200,000, 5.7% loan, all of the interest will be tax deductible as long as the total of your home loans is $1 million or less.
Cashing out: Even after the recent slump in home prices, many houses are still worth far more than the outstanding balances on their mortgages. In such cases, home owners often refinance for larger amounts, pulling out cash.
Example: Your home is appraised at $300,000, and your current loan balance is $200,000. You find a lender willing to provide you with an 80% loan-to-value mortgage, so you borrow $240,000.
Thus, you pay off the old $200,000 loan and pocket $40,000.
Strategy: The best time to get a cash-out mortgage is when you’re planning an addition to your home, or if you plan a substantial renovation. If you spend the cash from the home loan in this manner, all the interest on the refinanced loan will be deductible.
If you don’t use any or all of the cash for home improvement, the excess will be considered home-equity debt.
Example: You refinance a $200,000 loan with a $240,000 loan, as above, and spend $20,000 putting in a new bathroom. You use the other $20,000 to buy a car.
Result: Of your new loan, $220,000 is considered “home-acquisition debt,” so interest on this amount is deductible. The other $20,000 is considered “home-equity debt,” which falls under different rules.
How it works: The interest on home-equity debt of $100,000 or less is deductible no matter how it’s spent. If you use the $20,000 from your cash-out mortgage to buy a car, the interest on that $20,000 probably will be fully deductible (as long you don’t owe more than $80,000 on a home-equity loan or line of credit, which would push you over the $100,000 deductibility threshold).
Trap: For home-equity debt to be fully deductible, the total mortgage debt on the house cannot exceed its value.
In the above example, where the home is appraised at $300,000 and home-acquisition debt after refinancing is $220,000, interest on only $80,000 of home-equity debt will be deductible.
Caution: Be especially careful about using cash-out mortgage money for expenses other than home improvements if you must pay the alternative minimum tax (AMT).
Why: If you are subject to the AMT, home-equity debt is subject to the same $100,000 limit for deducting the interest. However, the deduction is available only if the money is used for home improvement.
If you are subject to the AMT and use home-equity debt to pay off consumer debt, buy a boat, etc., you can’t take a deduction for the interest.
AHEAD ON POINTS
When you refinance a mortgage, you may pay “points” up front.
Example: You refinance a $200,000 loan and pay two points (2%), or $4,000. Paying points will reduce the interest on a loan, so it may be worthwhile if you’ll be in the house for at least several years.
Tax treatment: When a mortgage is refinanced, points you pay can be deducted over the life of the loan.
Example: You pay $4,000 in points for a 30-year (360-month) loan. Every month that this loan is outstanding, you can deduct $11.
Payoff: If the loan is paid off early, all of the not-yet-deducted points can be deducted at once. This might be the case when the house is sold or when the refinanced loan is refinanced once more.
In the case of a re-refinance, the old points can be deducted immediately and you can begin a monthly schedule for deducting points on the new loan.
Exception: If you refinance with the same lender, you can’t deduct the old points. Instead, those points are folded into the new point-deduction schedule.
Example: You have $3,000 worth of nondeducted points when you refinance with the same lender and pay $4,000 in points on the new loan.
Now you have $7,000 in points to deduct. On a 30-year loan, you would deduct $19 ($7,000 divided by 360) each month.
Loophole: If you use a cash-out mortgage and use some of the proceeds to improve your principal residence, a corresponding portion of the points can be deducted up front.
Example: You refinance a loan secured by your principal residence, borrowing $240,000 and paying $4,800 in points. Of the $240,000 that you borrow, $40,000 (one-sixth) is used for home improvements.
Result: You can deduct $800 (one-sixth of $4,800) immediately. The other $4,000 paid for points can be written off over 360 months (30 years).
However, if the refinancing and home improvements were done on a second home, the entire $4,800 would have to be written off over the life of the loan.
In all cases, you take deductions for points paid on Schedule A of your tax return — as an interest expense — so the tax break is available only if you itemize deductions.