Locking in a lower home mortgage rate - Personal Finance - Column

Healthcare Financial Management, Feb, 1992 by William G. Kistner

Mortgage rates have been hovering below 9 percent since the latter par of 1991. While some economists predict that rates will go lower, others are growing concerned that rates may have bottomed out. For homeowners with high fixed-rate or adjustable-rate mortgages, now might be a good time to refinance.

Quantifying potential savings from refinancing is complex. It involves determining whether the current value of after-tax savings from a lower interest rate exceeds the up-front cost of refinancing. Such savings are measured over the time period during which a taxpayer expects to own the house, which may be significantly shorter than the term of the mortgage.

Typical refinancing costs include:

* Loan discount points and origination fees on the new mortgage, usually about 2 to 4 percent of the mortgage amount;

* Appraisal and survey fees;

* Title search fees and title insurance premiums;

* Recording fees;

* Credit report charges; and

* Prepayment penalties.

Savings calculation. To determine the exact savings from refinancing, two computations are required. First, all costs and benefits are converted into "after-tax" values to be comparable. For example, after-tax front-end refinancing costs are compared to after-tax interest savings.

Second savings and costs are reduced to their present value. Costs incurred to refinance are real costs today. Savings, however, will be spread over a future time period. As a result, dollars saved five, 10, or 15 years from now are worth only a fraction of that amount today. For example, a monthly savings of $150 will be worth approximately $32 in 20 years, assuming an 8 percent discount rate.

General guidelines. If a person intends to keep a home for another four to six years, and the difference between the current mortgage rate and the new mortgage rate is 2 percent or more, it is time to think seriously about refinancing.

The following simple calculation determines how many months it would take to recoup refinancing costs: divide the total amount of estimated refinancing costs (deductible and nondeductible) by the anticipated reduction in monthly mortgage payments (that is, the difference between existing monthly payments of principal and interest and the new monthly payment). If up-front costs will be recovered before the anticipated date of selling the house, then refinancing is advantageous.

For example, assuming that a new mortgage will reduce the monthly payment by $200 and that it will cost $3,600 to obtain the new mortgage, the formula ($3,600 divided by $200) indicates it will take 18 months to recover the costs of refinancing. This computation is only a guideline, however. It does not take into consideration income tax effect, present value, and opportunity costs.

Total refinancing costs traditionally run approximately 3 to 5 percent of the new loan amount. But because the market is very competitive, one should shop around.

Tax considerations. When refinancing, many people are tempted to take advantage of the lower interest rates by borrowing extra cash, assuming that the interest will be fully deductible. But tax law only allows a home mortgage interest deduction on acquisition debt (to purchase, construct, or improve one's principal home and one other personal residence) up to $1 million, plus home equity loans totaling $100,000.

Interest paid on refinanced debt in excess of the outstanding balance of the acquisition debt being replaced will be fully deductible home mortgage interest only in two circumstances:

* Interest on extra mortgage debt used to pay for substantial improvements to a home (for example, remodeling a kitchen, building an addition, or putting in a pool) is fully deductible as long as the total of such loans and other acquisition debt is less than $1 million; and

* Interest on up to $100,000 of additional mortgage debt is fully deductible as a home equity loan. The proceeds can be used for any purpose-a child's tuition, a new car, or to pay off outstanding credit card balances. Congress is reconsidering this existing tax break.

Finally, care should be taken if the mortgage being refinanced was taken out before October 13, 1987. Extending the term of the refinanced debt beyond the period remaining on the debt being replaced could jeopardize all or part of the home mortgage interest deduction for interest paid after the date the original debt would have been paid off.