Prepaying your mortgage can have tax consequences

Uncle Sam wants you -- to be a homeowner. The proof is in the mortgage interest deduction gift doled out for years by the Internal Revenue Service.

But managing a mortgage involves more than just waiting for a tax refund. Experts say people need to keep tax rules in mind when doing everything from prepaying principal to refinancing the loan.

"Mortgages actually are a great financial tool," says Roxanna Pletchan, a certified financial planner with Lassus, Wherley & Associates in New Providence, N.J. "It doesn't mean I would buy a house for tax reasons ... but it's a great tax benefit owning a home in most instances."

On the surface, mortgage tax regulations look relatively harmless and straightforward, but they can become complicated. So a review of home loan basics is in order.

The obvious starting point is the interest tax deduction, which allows most mortgage holders to deduct all the interest they pay each year. The deduction applies to people with just one mortgage on a primary residence, as well as those with a combination of loans.

"When buying a home, you can take out a loan for up to $1 million and deduct the interest," says Thomas Langdon, a professor of taxation at The American College in Bryn Mawr, Pa.

Making points
People can deduct some of the cost of getting a new or refinanced mortgage, as well.

"Generally, points paid when you obtained the mortgage are going to be deductible, even if they're paid by the seller," says Sandra Raiter, a tax analyst with the tax preparation firm Jackson Hewitt Inc. of Virginia Beach, Va.

Points paid on the purchase of a primary residence are usually deductible in the year of the purchase. However, if they exceed the combined amount of the down payment and other closing costs, only the amount in points that is the equivalent of those other items is deductible in the year of the purchase. The rest must be spread evenly across the loan term. Fees for services like title searches and appraisals are not deductible.

So, a borrower who puts down $10,000 on a $100,000 home, and pays $2,000 in points and $1,000 in closing costs, would be able to deduct the full $2,000 in points the first year. The other $1,000 in costs and the down payment wouldn't be deductible.

Deductions for points paid to purchase a second home must be spread over the term of the loan. In most cases, that holds true for a refinance of a first mortgage, as well.

Refinancing and taxes
Otherwise, somebody who refinances by getting a new loan to pay off an old loan of equal value faces standard first-mortgage restrictions. But someone who decides to increase the loan size to capture some equity money has to contend with slightly different rules.

These so-called "cash-out refinance" loans let somebody with, say, an old $80,000 first mortgage, refinance to a new $90,000 loan and use the resulting $10,000 for other expenses. In such instances, the additional $10,000 would be treated as home equity debt, of which only the first $100,000 -- rather than $1 million -- in principal carries tax-deductible interest.

Pletchan urges caution when refinancing because the move can require a change in weekly payroll deductions. "If the interest break is significant, you may need to take another look at your withholdings to avoid being caught short at the end of the year."

The IRS levies fines if shortfalls reach certain levels, so Raiter of Jackson Hewitt recommends people assess their tax liability ahead of time.

"Depending on your tax bracket, if you're losing $100 worth of deductions because of the refinancing, then that would mean you would owe an additional $15 in tax at the 15 percent bracket," Raiter says. "That's kind of a good rule of thumb."

Benefits of owing money
Armed with this information, people can make better decisions, experts say. For instance, prepaying the mortgage in today's interest rate environment often doesn't make sense because tax laws benefit those who sock money away.

Consider that the mortgage deduction reduces the effective, or after-tax, rate of a 7 percent loan to around 5 percent for somebody in the 28 percent tax bracket, according to Pletchan. Someone who makes extra mortgage payments ahead of time would be saving only the 5 percent interest by prepaying.

That's a relatively low rate of return compared to what's available in the stock market, which historically has returned 8 to 10 percent.

"If the other choice is to spend the money, then prepay your mortgage," says Pletchan. "If the other choice is to fund your 401(k), then fund your 401(k)."