Dear Dr. Don,

I am eight years into a 30-year, fixed-rate mortgage with an interest rate of 5.78 percent. I have been making additional payments toward the principal and, according to my revised amortization schedule, I am actually 13 years into a 30-year loan.

My question is: Is it wise to refinance into a 15-year mortgage at 3.875 percent fixed and lose the tax deduction, which I use to its fullest?

— Larry Leverage

Dear Larry,

I’d rephrase it to say that you’re eight years into a 25-year mortgage because your additional principal payments are shortening the loan term. By shortening the mortgage loan term, you’ve reduced your total interest expense.

The mortgage interest expense declines over time in an amortized loan, just by the nature of the loan. An amortized mortgage payment is sized to cover the monthly interest expense on the outstanding loan balance and to pay down principal over time, so at the end of the loan term the mortgage is paid off. By making additional principal payments, it doesn’t change the size of the required monthly payment, just how that payment is allocated to paying down interest expense and principal. It’s the acceleration of that pay down that shortens the loan term.

I understand your point about how refinancing at a lower interest rate will reduce your mortgage interest expense and by doing so, increase your tax bill. The key here is to not let the tax break be the tail wagging the dog when making financial decisions. Here’s a simplified example, using your interest rate numbers but assuming an interest-only loan of \$100,000.

Mortgage interest expense
 Existing Refinancing Difference Loan rate: 5.780% 3.875% -1.905% Loan balance: \$100,000 \$100,000 Annual interest expense: \$5,780 \$3,875 \$(1,905) Marginal federal income tax rate: 25% 25% Reduction in federal income tax paid based on mortgage interest deduction: \$1,445 \$ 969 \$(476) Interest expense net of deduction value: \$4,335 \$2,906 \$(1,429)

What the table illustrates is that while you’ve paid an extra \$476 in federal income tax in this example, because of the reduction in the mortgage interest expense, you’ve still increased your annual cash flow by \$1,429, net of the higher tax bill. If you don’t know your marginal federal income tax rate, you can use Bankrate’s quick tax-rate calculator tool to figure it out.

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