Tax Savings in Interest Versus a Lower Interest Rate
The mortgage interest deduction helps lower the cost of homeownership for millions of Americans. For many people, it also complicates what should be a straightforward decision -- whether or not to lower your interest rate by refinancing. Generally, getting a smaller deduction isn’t a good reason not to lower your interest rate.
Spending for Deductions
Tax deductions can be extremely valuable. Depending on your federal and state income tax bracket, a dollar of deductions could save you anywhere from 10 cents to more than 50 cents in taxes if you have a high income and live in a high-tax state. If you take a dollar that you would spend anyway and make it tax deductible, you’re essentially getting between 10 and 50 cents in free money. This cuts the other way, too. If you waste a dollar just to get a write-off, even after your tax savings, you have still thrown away between 50 and 90 cents. All things being equal, you come out ahead paying a lot less interest and getting a little less tax shelter with a 4.25 percent mortgage than you do with a 6.25 percent mortgage.
Lower Your Rate
Lowering your mortgage interest rate won’t save you as much as it may eventually seem because you’ll lose some tax savings, but you’ll still save money. Over the life of a 30-year $400,000 mortgage at 6.25 percent, you’ll pay $486,632 in interest. If you drop your rate to 4.25 percent, you’ll pay $308,393 in interest and save $178,239. In exchange for the $178,239 in interest savings, you’ll give up about $62,384 in tax savings, assuming that your marginal federal and state tax rate is 35 percent. If your tax rate is lower, you give up even less.
The Drawback to Refinancing
Refinancing to a lower rate to save money may have one drawback, though. If you have paid on your loan for a while and you refinance to another loan with the same initial term, you'll take longer to pay off your loan and you'll pay more interest. One way around this is to refinance to a shorter-term loan. For example, if you took out a 30-year loan nine years ago, refinance it to a 20-year loan instead of a 30-year one.
Buying Down Your Rate
While lowering your interest rate is almost always a good idea, spending money now to reduce your rate for the future might not be. First of all, when you do this, you’re taking a lump sum of money out of your bank account of investments. If an opportunity arose to put that money to work on a lucrative investment, you wouldn't be able to act on it. Second, since money that you put into your loan is either not deductible or spread out over time and you give up deductions by lowering your rate, you can come out behind. Since these calculations can have many moving parts, an accountant can help you figure out the best strategy if you plan to refinance your mortgage.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.