Don’t let taxes determine refinance move
Dear Dr. Don,
I have owned a $400,000 single-family home since 2009. I made a 20 percent down payment on the home and have a fixed-rate mortgage of 5 percent on the property.
I plan to live in this house for 10 years or more. I am interested in your opinion about whether I should make an additional principal payment of $700 each month or to refinance the home with a 15-year fixed-rate mortgage at about 3.5 percent.
Or, would the tax deductions on the existing mortgage generate tax savings great enough to cancel the benefit of making additional principal payments or refinancing to a 15-year fixed-rate loan. What’s the best choice?
My other concern is that I have more than $70,000 in savings, and I am wondering if I should get another house with this money or invest it somewhere more profitable. Could you please give me some options?
— Ken Chooses
With a planning horizon of 10 years, it’s easy to recommend you refinance at today’s lower rates. You’re only three years in on your existing loan, which I assume by the rate is a 30-year fixed-rate mortgage. So shortening up by a dozen years is a big financial commitment. Still, the existing mortgage plus your planned additional principal payment of $700 per month is $ 236.73 more than the 15-year mortgage payment.
The table below shows a scenario that approximates your situation, assuming you’re in the 25 percent marginal federal income tax bracket, and you can fully utilize the mortgage interest deduction on your income tax return. I assume an additional principal payment on the 15-year loan, so the monthly cash flow is the same regardless of which approach you take.
|Existing loan||Existing loan with additional payments||Refinancing|
|Loan term (months):||324||180||158|
|Additional principal payment:||–||$700.00||$236.73|
|Total monthly payment:||$1,717.83||$2,417.83||$2,417.83|
|Total interest expense:||$251,477.00||$128,741.00||$75,903.00|
|After-tax savings (25 percent federal rate):||–||$92,052.00||$39,629.00|
|After-tax savings net of closing costs ($5,000 estimate):||–||–||$34,629.00|
Don’t let taxes be the ‘tail wagging the dog’ in making a mortgage refinance decision. Losing the tax deduction reduces your after-tax savings, but in the example above, you’re still saving almost $35,000. You want to compare the effective rates on your loans, not the size of the tax deduction. Holding on to a 5 percent mortgage when you can get 3.5 percent financing doesn’t makes sense from a tax perspective. It can make sense if you don’t plan on being in the house long enough to recoup the closing costs in the form of interest savings.
As to how to invest $70,000 in savings after making sure you have an emergency fund that covers three months to six months in living expenses, take a look at your overall portfolio. You already have $400,000 invested in real estate. Do you want to add to that asset allocation in your portfolio? I wouldn’t, unless you have a substantial investment portfolio.
Focus on the life goals you want the investments to finance in the future, balance it against the risks you’re willing to assume when investing, and find the investment option that you’re comfortable with to achieve these goals.
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