Q. We are considering refinancing our mortgage to take out some of our equity and help pay off some of our daughter and son’s student loans. We will be getting a lower interest rate but we will have a higher mortgage so our monthly payment will remain about the same. A friend warned us that we might lose some of our interest rate tax deduction by refinancing. We don’t understand this since when we run the amortization schedules, we will pay at least $1,000 more in interest on the new mortgage than we will pay on our current mortgage this year. If it matters, our new mortgage will be $325,000 at 4 percent and our current mortgage is around $200,000 at 6 percent. Won’t our interest deduction be higher now? If for some reason it won’t be, should we forget about refinancing? We’d really like to help our kids get out of debt and other than selling investments and thought this would be the best way to achieve that goal.
A. Your friend is correct about the tax deduction but that doesn’t mean refinancing wouldn’t be a good option for meeting your goal or in general for that matter. Current law limits home mortgage deduction to interest paid on qualifying mortgages. Qualifying mortgages are those taken out on or before October 13, 1987, mortgages for $1 million or less taken out after October 13, 1987, to buy, build or improve your home and home equity mortgages up to $100,000 not used to buy, build or improve your home limited to the fair market value of your home reduced by any of the two other mortgages listed.
The IRS distinguishes between acquisition indebtedness and home equity indebtedness to determine if your mortgage interest is deductible. Debt incurred to acquire, construct or substantially improve your home is tax deductible. Indebtedness is reduced as the debt is paid off and cannot be increased by refinancing. Refinancing of an acquisition debt is considered acquisition debt to the extent it does not exceed the principal outstanding on the loan immediately before the refinancing. Debt secured by the home which exceeds the acquisition indebtedness is deemed home equity indebtedness and is limited to the lesser of fair market value of the home minus total acquisition indebtedness on that home or $100,000 ($50,000 Married Filing Single), whichever is less.
Acquisition and home equity debt may be combined in a single loan when claiming interest deductions. Refinanced debt amounts in excess of the prior debt’s outstanding balance can be combined in a single loan. Interest on home equity money is not deductible for Alternative Minimum Tax purposes.
If your current mortgage is $200,000 and you refinance to a new $325,000 first mortgage you will be able to claim an interest deduction of the interest paid on $300,000. You will be allowed to include interest paid on the amount equal to your current loan plus $100,000 using the home-equity rules. You’ll have no deduction for the interest attributable to the $25,000 of the $325,000.
Regardless of the tax deduction, switching from a 6 percent to a 4 percent interest rate will save you money as long as your closing costs for the new mortgage are reasonable. To compare apples to apples, over an 18-year period you would pay a total of $327,525 on a $200,000 loan at 6 percent versus a total of $280,886 at 4 percent. A meeting with a tax professional may be of value.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624