Last week's The Monthly Payment Economy garnered enough feedback to discuss some of the issues raised. First, I need to first point out that I inadvertently edited out an important point. Surprisingly only one person alluded to it. All the assumptions used in showing how refinancing a mortgage actually increased total payments over the term of the mortgage were based on paying off the mortgage. If the house is sold prior to being paid off, then refinancing can be beneficial. The principal balance will be larger throughout the life of the mortgage after refinancing, but the amount saved through lower monthly payments is greater than the difference in the principal balance.
While most comments were personal stories relating to how they reduced their mortgage term by going to a 15-year mortgage, there were a few that took exception with the basic premise. I think the economy has been buoyed by consumers and companies taking on a record amount of debt. One reader pointed out that there are millions of people that are responsible and are saving money. I do agree that there are. But, there are far too many that are not. Our economy hinges on the margin. It is the marginal supply and demand that sets prices. During the boom, the marginal consumer was getting raises, experiencing an increasing net worth due to asset appreciation. This increased consumption. Now the economy is experiencing the opposite. Plus there is still the overhang of debt that was built up during the good times. Right now, the marginal consumer is financially over-extended. When the marginal consumer fails it causes a ripple effect - marginal companies will also fail. When consumers are companies are over-leveraged they are more apt to become one of these marginal players in the economy. Record high bankruptcies and delinquencies are evidence that there is stress at the margin throughout the economy. The other problem has been companies leveraging themselves to sell to a leveraged consumer. The automakers as well as the aggressively growing retailers come to mind.
I also received some comments that refinancing should not be considered unless the interest rate can be improved by 200 basis points. I'm guessing the reader is suggesting that I used a scenario that would yield the results I was looking for. I was using a real world example, mine, that I think is a common situation. Especially lately and going forward. True, the bigger the reduction in the interest rate the better. But there are not many mortgages outstanding that are 200 basis points above current rates and refinancing activity is booming. The previous refinance booms removed most of the mortgages with rates over 8.0%, or at least those that would be willing to refinance. Also, I have read several articles quoting mortgage professionals questioning why anyone holding a mortgage with an interest rate above 7% has not refinanced yet.
The December issue of The Federal Reserve Bulletin was an article titled Mortgage Refinancing in 2001 and Early 2002. The article was based on surveys done on those that refinanced from January 2001 to June 2002. This time period does not include the latest boom. From January 2001 to June 2002, 23% of all homeowners refinanced their mortgage. There was an additional 26% that refinanced prior to 2001. Combined, about 49% of those with mortgages had refinanced by June 2002. Those that refinanced during this period decreased the interest rate from 8.65% to 6.82%. The overwhelming majority, 77%, refinanced a 30-year mortgage to another 30-year mortgage. This resulted in longer maturities for 74% of refinancings, by an average of six years. The article also noted that the average mortgage rate on all existing mortgages for those that have not refinanced yet was 7.55%.
Even the Fed paper discusses the "amount saved" from refinancing. The paper calculates that the annual savings of refinancing was $1,621 based on a reduction in the monthly payment by $135 for those that did not extract equity. Based on the percent of households that refinanced (10.9%) multiplied by the number of households (107 million), yields an annual savings of $13.1 billion. While this answers how much is saved right now, it does not address the total long-term cost. Since the Fed found that the average maturity lengthened by six years, the homeowner will save just under $39,000 over the next twenty-four years. But during the last six years, the homeowner will be paying $8,666 more per year than without refinancing, since the mortgage would have already been paid off and there would be n payments. This totals almost $52,000, or a cumulative $96 billion drag on the economy than if the refinancing had not been done.
As I said earlier, all these examples include the assumption that mortgages are ultimately paid off. If the house is sold prior to being paid off, then refinancing can be very beneficial. For instance, in my example last week, if the homeowner sells the house after another five years, the mortgage balance in higher by $2,058 if refinanced, but the homeowner has saved over $8,100 in lower monthly payments. Even with $3,500 in closing cost, refinancing has saved the homeowner money.
Another aspect that needs to be considered when analyzing mortgage decisions is the tax effect. Last week I only mentioned it in passing since it can become a complicated issue. I think there is a general perception that the entire amount of mortgage interest paid should be used to calculate the after-tax cost of mortgage payments. This is not necessarily the case. Before I go any further, let me state I am not a tax attorney, tax advisor or anything remotely close to a tax expert. And I would appreciate it if anyone is an income tax expert please email me if I am incorrect. Since homeowners are able to deduct mortgage interest from their gross adjusted income to determine taxable income, real estate professionals often discuss the tax benefits of owning and mortgage payments would actually be lower because of the tax treatment. The calculation usually takes into account interest payments and property taxes. Using the example last week and utilizing a 27% marginal tax rate, the tax savings
The assumptions going forward:
- Homeowner is in the 27% marginal tax rate and stays there and the tax rates do not change.
- The standard tax deduction increases by $250 each year.
- Property tax rates are 2.25%
- House is valued at $175,000 and does not increase or decrease in value.
- Refinancing scenario uses the example from last week, paying the closing costs up front after six years.
Now, I really feel like an economist.
The amount of interest paid going forward by either continuing with the original mortgage or through refinancing is about the same. Without refinancing, an additional $134,824 will be paid in interest over the last 25 years of the mortgage. Refinancing will increase the amount of interest paid to $136,481 over thirty years. But the after-tax effect is much different. During the first year, the homeowner would experience a tax savings of $353 by keeping the original mortgage. This would decrease the overall yearly savings from $1632 to $1279 by refinancing. But this does not remain constant since the amount of interest paid decreases every year.
Original mortgage: 2003 interest paid = 8,337.70, * 27% marginal tax rate = 2,251.18 in tax savings.
Refinance: 2003 interest paid = 7,029.84 * 27% = 1,898.06 in tax savings.
Many real estate professionals stress the tax savings when selling homes to buyers, especially first time buyers. However, this is conceptually very wrong. Tax payers are entitled to the standard deduction, which for 2002 is $7,850. Thus only the additional amount over the standard deduction can be considered extra savings.
In 2003, the standard deduction will be $8,100 (I believe, it has been going up $250 per year for several years and for 2002 it was $7,850).
Assuming a 2.0% property tax rate, probably a bit low, and assuming the house is appraised fro $175,000, the tax bill is $3500.
Mortgages are designed so more is paid in interest in the early years and more principal is paid during the later years. Since the amount of interest paid is reduced each year, there comes a time when the mortgage interest paid is less than the standard deduction.
By including the amount of property tax with the mortgage interest, it is financially better to take the standard deduction in 2010 under the refinancing scenario, but not until 2012 under keeping the original mortgage. Admittedly, this is very simplistic and does not account for other expenses that can be itemized, most notable being charitable contributions. Oh yeah, some states have a state income tax that can be deducted from federal taxes. One nice aspect from living in Texas!
The cumulative amount of interest paid that the homeowner would benefit from itemizing when combined with $3,500 in property tax is much higher by not refinancing. Under the original mortgage, the total amount of interest paid from 2003 to 2011 is $69,832, compared to $47,130 by refinancing. The after-tax savings by not refinancing is $6,129. Obviously, individual circumstances can change the outcome, but it does continue to show that refinancing is not the Holy Grail. Another way to squeeze a couple more years out of mortgage interest is to double up property tax payments every other year, along with charitable contributions, then take the standard deduction every other year. For example, assuming mortgage interest paid in 2003 is $7,000, which is less than the $8100 standard deduction. Take the standard deduction in 2003 and hold off paying 2003 property tax until January 2004. Then pay the property tax for 2004 in December 2004. This way, using the $3,500 assumption from above, $7,000 can be itemized, plus the mortgage interest of $6,700. This would allow an additional $1,100 in deductions over the two year period.
I am not offering personal financial advice. Individual situations can alter the outcome of a hypothetical situation. I thought I would share the analysis I did recently that I have not seen addressed in the mass media.
Now, I've had enough regarding refinancing. Next week I'll get to first quarter earnings. This goes against my better judgement, but I plan on offering a quick "how-to" on analyzing quarterly earnings reports. The last time I offered it there was very good response. If you have a company you would like to submit, please email me before the weekend. I will choose a few based on popularity and if anything can be found to explain the "red flags" we look for.