Does it Make Sense to Refinance a Mortgage?


Tax Issue

The chance to refinance a mortgage and get a lower interest rate is sure to get a homeowners’s attention. Most people assume that refinancing will put them ahead economically, but that’s not always the case. Any number of situations can arise which will make the decision to refinance unwise. Refinancing a mortgage should be done with just as much care as was put into the decision to obtain the original mortgage. Sometimes a mortgage refinance makes sense. Other times, it is better to stay with the current arrangement.

Applicable Tax Law

  • Home mortgage debt, including acquisition debt, home equity debt, and points or loan origination fees paid to refinance a mortgage, generate interest which may be deductible as an itemized deduction on Schedule A, Form 1040.
  • Total acquisition debt on main and second home combined is limited to $1 million ($500,000 MFS) at any time.
  • Debt secured by the home and used to refinance acquisition debt is treated as acquisition debt up to the balance of the old mortgage principal just prior to refinancing.
  • Debt used to substantially improve the home is acquisition debt.
  • Refinanced debt in excess of the old acquisition debt principal may qualify as home equity debt.
  • Total home equity debt on main and second home combined is limited to the small of $100,000 ($50,000 MFS), or the total of each home’s FMV reduced (but not below zero) by acquisition and grandfathered debt for each home on the date the last debt was secured by the home.

Tax Planning Strategies

  • Homeowners may consider refinancing their mortgages for a number of reasons.
  • The interest rate on a mortgage is directly tied to how much the monthly payment is. Lower rates usually mean lower payments. If a borrower’s credit score has improved since the current mortgage was obtained, or market conditions have changed to make lower interest rates available, refinancing to obtain a lower interest rate will allow the borrower to build up equity in the home more quickly.
  • A homeowner may want to adjust the length of his or her mortgage. A mortgage with a longer term will reduce the amount paid each month. However, this will also increase the total amount he or she ends up paying in the interest over the life or the mortgage. Shorter-term mortgages generally have lower interest rates. Plus, they are paid off sooner, further reducing total interest cost. The trade-off is generally higher monthly payments because more principal is being paid each month.
  •  A homeowner with an adjustable-rate-mortgage (ARM) must adjust to monthly payment increases or decreases as interest rates change. He or she may want to switch to a fixed-rate mortgage to obtain some peace of mine by having a steady interest rate and monthly payment. This is especially true if he or she believes interest rates may rise in the future.
  • A homeowner may choose to refinance a mortgage if the home’s value is greater than the balance owed on the current mortgage. He or she may do this receive the difference as a cash source for such things as making home improvements or paying for a child’s education.


When deciding whether or not to refinance, the home owner should calculate the financial benefit of refinancing over a number of years. If the taxpayer plans to stay in the house until the mortgage is paid off, it may also help to look at the total interest that will be paid under both the old and new loans. Another good thing to compare is the equity build-up in both loans. If the borrower has had the original loan for a while, more of the payment is going to principal, building up equity. If the new loan has a term longer than the remaining term on the existing mortgage, less of the early payments will go to principal, slowing down the equity build-up in the home.


Refinancing Calculators. Many online mortgage calculators are designed to calculate the effect of refinancing a mortgage. These calculators usually require information about the current mortgage (such as the remaining principal, interest rate, and years remaining on the mortgage), the new loan being considered (such as principal, interest rate, and term), and the upfront or closing costs for the loan. Some may ask for the borrower’s tax rate and the rate of interest on investments (assuming the savings will be invested). Refinance calculators will show the amount that will be saved compared with the costs incurred so that the borrower can determine whether the refinancing offer is right for him or her. The National Bureau of Economic Research has an example of a refinancing calculator at


Possible Risks

The proportion of a monthly mortgage payment that is credited to the principal of the loan increases each year, while the proportion credited to the interest decreases each year. In the later years of a mortgage, more of the monthly payment applies to the principal and helps build equity. By refinancing late in the mortgage, the amortization process is restarted and most of the monthly payment will be credited to paying interest again and not to building equity.

The current mortgage may have a prepayment penalty. Carefully consider the costs of any prepayment penalty against the savings expected to be gained by the refinancing. Paying a prepayment penalty will increase the time it will take to break even when balancing the costs against the expected savings. If refinancing with the same lender, ask whether the prepayment penalty can be waived.

The total monthly savings gained from lower monthly payments may not exceed the costs of refinancing if the homeowner is planning to move in the near future.

If the borrower’s credit score has fallen since the current mortgage was obtained, the new loan may require a higher interest rate.

If housing prices have fallen, the house may not be worth as much as what is owed on the current mortgage. Even if home prices have stayed the same, a loan which includes negative amortization (the monthly payment is less than the interest and the difference is added to the principal) may result in more being owed on the mortgage than was initially borrowed. Such a situation would make it difficult to refinance.

When refinancing to cash for something such as home improvements or higher education, equity is being taken out and it will take time to build the equity back up. This means that if the borrower needs to sell his or her home, they will not pocket as much money after the sale.

Refinancing is not the only way to decrease the term of a mortgage. By paying a little extra on principal each month, the borrower will pay off the loan sooner and reduce the term of the loan. For example, adding $50 each month to the principal payment on the mortgage in Example #1 reduces the term by three years and saves the borrower more than $27,000 in interest costs.