There are numerous costs in any mortgage financing. These costs may include loan origination fees, application fees, credit checks, appraisal fees, attorney fees, title insurance, transfer taxes and others. The lender may also charge discount “points” that amount to prepaid interest. These points can run 1% to 3% of the loan.

Points, unlike loan origination fees, are deductible as interest. However, the points that are paid upon acquisition of a home are deductible in a lump sum. Points on refinancing are deductible over the life of the new loan. The total closing costs on a refinancing can easily run 4% to 5% of the loan amount, although you may be able to get a break by careful shopping or dealing with your current lender.

To really compare apples to apples, you should compare the after-tax cost of the new mortgage with the old. Since mortgage interest is deductible, the after-tax cost of the loan equals the principal and interest payment after deducting the taxes saved attributable to the deduction. The computation is fairly simple in most cases. The number-crunching gets a little more complex if the change in mortgage interest deductions causes you to cross over into another bracket, but the theory is the same. State taxes should also be considered if your state allows a deduction for home mortgage interest.

For example, Tim originally borrowed $103,000 for 30 years at 9.5% four years ago to buy his home. Today he can refinance his home for 30 years at 5.5% at a total cost of 4% of the loan amount. Tim’s loan balance today is $99,982. He is in the 25% tax bracket. The cost to Tim to refinance is $3,999 (assume no deductible points). Tim decides to refinance a total of $103,981 ($99,982 + $3,999). His current monthly mortgage payment is about $866 of which about $792 is interest. That makes his after-tax payment about $668 [866 - (792 x 25%)]. His new mortgage payment will be about $590 of which roughly $477 will be interest, for an aftertax cost of $471. Tim will be saving, after tax, about $197 per month. At that rate, it will take about 20 months (3,999/197) before he breaks even. If Tim plans to stay in the house longer than that, then refinancing makes sense.

Of course, this brief article is no substitute for a careful consideration of all of the advantages and disadvantages of this matter in light of your unique personal circumstances. Before implementing any significant tax or financial planning strategy, contact your financial planner, attorney or tax advisor as appropriate.

Shawn Powell Certified Financial Planner®