Question: When you refinance, should you pay your closing costs up front, or roll them into the loan amount? Are there any tax differences?
Answer: Mortgage rates are so low these days that you may be able to reduce your monthly payments by doing a no-closing-costs refinance where there is literally no cost to get a new, lower-rate mortgage. In that case, the savings are immediate and no complicated analysis is necessary.
However, if you want to get an even lower mortgage rate by paying points and closing costs, it can be relatively expensive.
Closing costs typically total more than $3,000, and a point is a fee equal to 1 percent of your loan amount that is used to buy down the interest rate.
Most borrowers add those costs to their loan amount because they don’t have thousands of dollars sitting in the bank to pay the costs out of pocket.
But if you add the closing costs to your loan amount, you end up paying more in the long run because you are paying interest on your closing costs in addition to the original loan balance.
For example, let’s say you want to refinance your $300,000, 30-year fixed-rate loan with a 4.25 percent fixed-rate, also for 30 years. Let’s further assume that the payment on the current loan is $1,750 per month. By reducing your interest rate to 4.25 percent, your payments on the new $300,000 loan drop to $1,475 per month, (I’m rounding off all the numbers to make the example’s easier to follow) which would be a savings of $275 per month. To get that rate, you would have to pay $3,000 in closing costs plus 2 percent of your loan amount, or $6,000, for a total of $9,000. You would recoup those costs in just over 33 months due to the $275 monthly savings.
If instead of paying those closing costs in cash you added the $9,000 to your loan amount, the monthly payments on a $309,000 loan would be $1,520. That means you would save only $230 per month compared to your current payments, extending your break-even point to just over 39 months.
But that’s not the only consideration. After you pass the break-even point, you would continue to pay $45 per month more with the larger loan amount than you would have paid with the smaller one ($1,520 vs. $1,475). Over the remaining life of the loan, that totals $14,445.
Of course, if you don’t have an extra $9,000 lying around, this is an academic argument. And the reality is that few people actually hold a 30-year fixed rate mortgage for 30 years. Most people pay it off within about seven years or less, by either refinancing or selling their home.
For tax purposes, there is no difference between paying closing costs in cash or adding them to the loan. The only tax-deductible portion of these costs are the loan fees. In the example above, the points totaled $6,000. This fee would have to be amortized over the life of the loan. $6,000 divided by 30 years is only $200 per year. If you’re in the 28 percent income tax bracket, that saves you a whopping $56 in income tax. Hardly worth worrying about. The main purpose of refinancing is to save you money each month, not reduce your tax bill.
So while it is technically cheaper over the long run to pay your closing costs in cash, in the real world I think it makes more sense to add the closing costs to your loan amount.
E-mail Steve Tytler at economy@heraldnet.com.
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