When mortgage interest rates fall, it’s tempting to jump in feet-first with your refinance application. With lower interest rates, your bank account receives a little break, and you might have an opportunity to build more equity in your home by making extra principal payments. However, as with many good deals that seem difficult to pass up, there are some other things to consider. You may currently be eligible to claim a mortgage interest deduction on your tax return, but lowering your interest rate may affect your deduction and overall tax result.
Lower Interest Deduction
The most obvious effect of lowering your mortgage interest rate is a reduced mortgage interest deduction on your tax return. You’ll have to decide whether saving money each month on your monthly house payment or saving money each year on your tax return is more beneficial for you. For most folks, monthly payment savings will be much kinder to your overall financial picture, but if you experience an increase in income or lose the ability to claim a child or other tax credits, you might need all the deductions you can get to avoid paying additional taxes at the end of the year.
When you refinance your mortgage to get a lower interest rate, the lender will charge an origination fee for setting up the new loan. The good news is your origination fee is deductible as points. The bad news is this fee must be deducted over the life of the new loan. If you get a 30-year loan, you must spread your deduction out over 30 years. Origination fees from your first loan are usually fully deductible in the year you close the loan, so you’ll notice a big difference in your points deduction from your refinance efforts.
Itemized Deduction Limits
Mortgage interest is deducted as an itemized deduction on Schedule A. The IRS allows you to claim either itemized deductions or a standard deduction amount based on your filing status. You get the deduction category that is highest – if your itemized deductions equal more than your standard deduction amount, you can itemize and claim your mortgage interest. Lowering your mortgage interest could put you at risk for losing the mortgage interest deduction, depending on how close you are to the standard deduction amount. Standard deductions increase a little each year to accommodate increases in costs of living, so you’ll want to check page 2 of the current 1040 form to see what the amount is for your filing status.
Taxable Income Increase
Itemized and standard deductions are each used to lower your taxable income, which effectively lowers the tax you pay on that income. Regardless of whether you itemize or use the standard deduction, reducing your deductions means you’ll see an increase in taxable income – and that means an increase in the tax you pay. If you expect a big drop in your annual interest payments from the refinance, you’ll want to look at other ways to boost your deductions to avoid paying taxes at the end of the year. For example, consider donating extra clothing and household items to charity to account for the difference. Charitable donations are another type of itemized deduction, and you might be able to replace the difference in your regular interest deduction, and clean out your closets at the same time. A win-win! Consult with your tax preparer about other possible alternatives so you have enough time to plan for your increased taxable income.