As with most financial decisions, when it comes to refinancing a mortgage there are near-term costs and benefits and long-term costs and benefits. In Part 1, I reviewed a four-step framework as a starting point to determine if refinancing a mortgage is beneficial. The focus of that framework is to assess first, whether a refinance made sense in light of one’s larger financial objectives, and second, how soon the up-front costs of the refinance are paid for by mortgage-payment savings that come with a reduced interest rate. However, I acknowledged that the 4-step framework is just a starting place because it doesn’t fully account for long-term costs and benefits that are all-too-often overlooked or overstated. In this post, let’s look at those three factors and how to assess their impact on the decision to refinance:

1.         The total interest paid on your loan over time

Refinancing a mortgage at a lower rate could mean you pay less interest over the entire life of your loans, but it could also mean you pay more. Remember: In the beginning of a mortgage, you owe more interest, because your loan balance is still high so more of your monthly payment goes to paying interest. Later in the life of the loan, more of the payment goes toward principal. The result is that the timing of when you refinance (or when you decide to eventually sell your house) matters as you could end up paying more interest over the life of the loan because of how much interest is paid in the early years.

Paying more interest over the life of your home loan may still be worthwhile given the near-term flexibility monthly payment savings enables, but it’s important to make that decision understanding the details of the tradeoff. Let’s look at two examples to illustrate this:

Example 1:

First, let’s look at a homeowner who refinances their mortgage after three years to what would be an extremely attractive rate today. Here are the details of their original mortgage:

2017 Mortgage Amount	$400,000
Fixed-Rate Term	30 year
Fixed Rate	3.5%
Monthly Principal and Interest Payment	$1,796.18
Total Interest to be Paid over 30 years	$246,624

Now, suppose the homeowner refinances after 3 years. Here is where they are at the 3-year mark:

Remaining Principal on Original Mortgage	$374,442
Total Interest Paid after 3 years	$41,901

After Refinancing to an attractive lower rate (2.5%!), The new mortgage looks like this:

Mortgage Amount	$374,442
Fixed-Rate Term	30 year
Fixed Rate	2.5%
Monthly Principal and Interest Payment	$1,483.45
Total interest to be paid over 30 years	$158,599.93
Total Interest to be Paid over 30 year + Interest Already Paid	$200,501

Clearly, a $312 monthly-rate reduction is attractive, but notice the reduction in total interest paid over the life of the loan. When you add back the interest they paid over the first three years ($41,901), the total interest they pay is $200,501 – over $46,000 less than they would have paid over the life of the original mortgage. In Example 1, a refi is win-win! Reduced payments and reduced total interest to be paid.

Now let’s look at an example where the homeowner doesn’t refinance so early in the loan and has thus paid a chunk of the interest on the first loan:

Example 2:

For this example, we will assume all the same terms of the first mortgage in Example 1, except now the homeowner refinances after 10 years. Here is the remaining principal and total interest paid after 10 years:

Remaining Principal	$308,814
Total Interest Paid after 10 years	$126,152

After refinancing to the same lower rate as Example 1, the new mortgage looks like this:

Mortgage Amount	$308,814
Fixed Rate Term	30 year
Fixed Rate	2.5%
Monthly Principal and Interest Payment	$1,220
Total Interest to be Paid over 30 Years	$130,453
Total Interest to be Paid over 30 year + Interest Already Paid	$256,706

Here the homeowner gets a whopping in $576 reduction in their monthly payment. However, look at the total interest to be paid when you add back in the interest already paid in the first 10 years: $256,706. In Example 2, the homeowner will pay over $10,000 more in interest over the life of the two loans. Again, the reduced payment in the short term may be worth the additional interest in the long-term but understanding these details will inform the decision to refi.

The key takeaway here is that timing matters because the amount of interest paid each month is not constant. How long you have been paying your current mortgage and how long you plan to stay in your house are key factors in calculating the total interest you will pay over life of your loan. Don’t finalize a decision to refi without understanding how the total interest you will pay will be affected.

2.       What you plan to do with monthly savings from a refinance

An important component in calculating the overall benefit of a refinance is how the homeowner plans to use the extra cash that is available by reducing monthly payments. In Example 2 above, I said there may be circumstances where the cost of paying more interest in the long-term is worth the benefit of having reduced monthly payments. If you are considering a refinance, I encourage you to think in advance about what you will use the cash available from the reduced payment to fund. I commonly see the benefit being worthwhile when the homeowner plans to do things like:

• Pay down other high-interest debt
• Contribute to 529 college saving account
• Increase 401(k) or other retirement plan contributions
• Support a family member who needs financial support now

These are just a few examples, but notice that the first three examples listed could have a definable financial benefit (tax savings, investment gains, etc.), whereas the fourth (supporting a family member when they need the support) could be much more subjective. While examples like the fourth one can be difficult to quantify, I have seen numerous examples of where the ability to support a family member in the present was well worth $10,000 of interest over the next 30 years.  Again, these are just examples, but if you take time to think about what the reduction in monthly payments will allow you to do in advance, you can then decide if the long-term costs are worth it.

3.        Taxes (and tax-law changes)

The tax benefits of paying a mortgage are often overstated. In 2017, the Tax Cuts and Jobs Act (TCJA) became law and brought sweeping changes to the tax code.  Two of those changes directly impacted the cumulative benefits of a refinance. We will get into the details of the of these changes in a moment, but in case you don’t read on, I want to lead with the takeaway: Don’t factor into your decision to refinance (or let someone else factor into your analysis) a tax benefit that isn’t there!

Let’s look at the two changes and how this works:

First, the TCJA increased the standard deduction for a couple filing a joint return to $24,000 ($12,000 for single filers) and reduced those expenses which could be itemized. This matters because, since the TCJA, most people in this country are no longer itemizing their deductions as they don’t exceed $24,000. Consider the following example list of itemized deductions:

• SALT (State, Local and Real Estate Taxes) – $10,000 ($10,000 is the maximum that can be itemized)
• Mortgage Interest – $8,000
• Charitable Contributions – $5,000
• Total – $23,000 ($1,000 less than the standard deduction)

In this example, these deductions do not exceed the standard deduction, so this person wouldn’t itemize. They would receive zero benefit from the $8,000 of mortgage interest they paid. Thus, the tax-deduction benefit of a refi should only be looked at in years where the amount of interest paid will push the taxpayer’s deductions above the standard deduction. Often, this is the case in the early years of a re-finance when there is a higher percentage of interest being paid in each payment.

Second, since the TCJA was enacted, when homeowners refinance, the allowable interest is only deductible for the remaining term of the refinanced loan. For example, if you have a 30-year mortgage with 20 years left, and refinance into a new 30-year loan, you’ll only receive a mortgage interest deduction for 20 more years. Before the act, interest was deductible for the full term of the new mortgage. The eventual loss of the deduction may not be material if the payment reduction is still worth it, but in assessing total refi savings this is another way in which tax-savings can be overstated.

Conclusion

The taxes saved (or not saved), the total interest you will pay over time, and what you plan to do with your savings on monthly payments are each factors that could affect a decision to refinance a mortgage. Monthly payment reductions are a great benefit of refinancing a mortgage at a lower rate, but these three factors should be understood before making a final decision so that the decision you make is an informed one. If you need help understanding the costs and benefits of this or any major financial decision, I encourage you to ask for it! Please don’t hesitate to reach out: scott@cordantwealth.com.