Refinancing is the process of replacing an existing mortgage with a new one. You might consider refinancing to:
- Cut costs: If interest rates have fallen significantly since you got your loan, refinancing may decrease your monthly payment and reduce the interest you pay over the term of the loan.
- Change the type of loan: As circumstances change, you may find that the type of mortgage you have no longer suits you. For instance, if you have an ARM and are concerned about higher rates taking effect after your fixed period ends, you might refinance to get a 30-year fixed mortgage. If you already have a 30-year fixed, you might refinance to get a 15-year fixed, which would allow you to pay off the loan sooner and reduce the total amount of interest that you pay.
- Cash out: If you refinance and get a loan that exceeds your previous loan balance, you’ll receive a cash “refund” equal to the difference between your previous loan balance and the new loan balance. You can spend that money in any way that you wish, though lenders sometimes penalize borrowers who refinance for this reason by charging higher rates for the new loan.
Should You Refinance Your Mortgage?
A quick rule of thumb to follow in deciding whether to refinance is the 2% rule. This rule states that refinancing is worthwhile only if you can get a new loan with a rate at least 2% lower than your current rate.
Though the 2% rule is handy, it’s not definitive. A more thorough approach is to calculate how long it would take for the monthly after-tax savings that you’d receive from a new loan to cover your refinancing costs (which are usually equivalent to the closing costs of your original loan). To make that calculation:
- Calculate your monthly pretax savings, the “raw” difference between the amount of your current monthly payment and your new monthly payment. For this example, assume a current payment of $699.21 (a $100,000, 30-year fixed loan with an APR of 7.5%) and a new payment of $599.55 (the same loan with an APR of 6%). So the monthly pretax savings would amount to $699.21 – $599.55, or $99.66.
- Calculate your monthly after-tax savings. To do so, multiply your pretax savings by (1 – your federal income tax bracket). For this example, assume a tax bracket of 28%, which means you’d multiply $99.66 by (1 – 0.28), which equals $71.76.
- Divide the amount of your refinancing costs (we’ll assume $3,000) by your monthly after-tax savings. For this example, you’d divide $3,000 by $71.76 and get 42. This result is the number of months it’d take for your after-tax savings to pay back your refinancing costs. Only after this point does your refinancing begin to save you money.
By the 2% rule, you should not refinance in this situation, as the difference between the rates of the current loan and the new one is just 1.5%. But the more precise after-tax savings calculation shows that if you intend to keep the new loan for more than 42 months, it does make sense to refinance.
Tax Deductions for Refinancing Costs
Unlike closing costs on your original mortgage, you can’t write off refinancing costs on your taxes all at once. You can still deduct these costs, but your deductions must be spread out over the life of the loan, which means you’ll reap those tax savings only gradually and in small amounts.
