The biggest tax deduction each year for homeowners is usually the mortgage interest deduction. Under this deduction, homeowners can claim the interest they've paid on their mortgage loans, resulting in thousands of dollars in tax savings over the life of a mortgage loan. If you refinance your existing mortgage loan to one with a lower interest rate, you can save hundreds of dollars a month in mortgage payments. This will lower your annual mortgage interest deduction. But you shouldn't consider this a financial loss; you'll also be paying much less interest each year on a mortgage loan with a lower interest rate.
Each year on your taxes, you can deduct the mortgage interest on up to $1 million worth of mortgage loans if you are married and filing jointly and up to $500,000 worth of mortgage loans if you are either single or married and filing separately. You can also deduct the interest you've paid on up to $100,000 worth of home equity debt -- such as home equity lines of credit or home equity loans -- if you are married and filing jointly, or half that if you are single or married but filing separately. This tax deduction can save you a significant amount of money over the life of your mortgage loan, especially during its early years when the majority of your housing payment goes toward interest. According to the National Association of Home Builders, a family with a joint income of $80,000 and a mortgage loan of $180,000 at 5.5 percent interest will save $7,050 in taxes during the first five years that they own their home.
When you refinance your mortgage loan, you are essentially canceling an existing mortgage and replacing it with a new one. If your new loan has a lower interest rate, refinancing can shave hundreds of dollars off your mortgage payments. If you have a $180,000 30-year fixed-rate mortgage with an interest rate of 6 percent, you'll pay about $1,079 a month. If you drop the interest rate on that same mortgage to 3.5 percent, your monthly loan payment will fall to $808. That's a savings of $271 per month or $3,252 a year.
Refinancing's Impact on Your Deduction
Refinancing to a lower-rate mortgage will lower the size of your mortgage interest deduction for a simple reason: When you drop the interest rate on your home loan, you are also reducing the amount of interest you pay on your mortgage throughout the year. Because you are not paying as much interest each year, your annual deduction for mortgage interest will also drop.
You shouldn't, though, let a smaller mortgage interest deduction prevent you from refinancing. Because the interest tax deduction only gives you back a portion of what you pay in mortgage interest, the savings you make in interest payments throughout the life of your loan will easily outweigh the tax savings from a larger mortgage interest deduction.
Don Rafner has been writing professionally since 1992, with work published in "The Washington Post," "Chicago Tribune," "Phoenix Magazine" and several trade magazines. He is also the managing editor of "Midwest Real Estate News." He specializes in writing about mortgage lending, personal finance, business and real-estate topics. He holds a Bachelor of Arts in journalism from the University of Illinois.