The Tax Impacts of Home Mortgage Refinancing: An Analysis and a Model

Abstract This paper provides pertinent information for investors about refinancing their mortgages. It discusses the input variables and how to compute the breakeven number of months when deciding to refinance a mortgage. Interest rate tax effects that are normally ignored by investors when making their refinancing decision are incorporated. A number of scenarios are provided that vary the mortgage amount, term and interest rate. Depending on the term and interest rate, the breakeven varies from two to six years for a $200,000 mortgage and from two and a half years to ten years for a $100,000 mortgage. When considering the value of the lost interest deduction, the number of months required to breakeven increases by about 50%. An Excel model was developed to perform this analysis. Motivation and Previous Research There has been a tremendous increase in home mortgage refinancing over the last few years. Samuelson (2003) notes that approximately 40% of home mortgages have been refinanced over the past two years, while Krampf (2002) indicates that over 1 trillion in mortgages (53% of total mortgage originations for one to four family homes) were refinanced in 2002. In addition to the potential economic impact of lower monthly mortgage payments, the Federal Reserve has estimated that higher home values have added 3.1 trillion to household wealth. Samuelson (2002) also notes that for 2002, "cash out" refinancings and new home-equity loans totaled nearly $300 billion. As described by Brady, Canner and Maki (2000), this refinancing activity likely boosted both consumption spending and investment. The literature on mortgage refinancing from the borrower's viewpoint includes several interesting articles. Valachi (1982) uses the internal rate of return to evaluate mortgage refinancing. G-Yohannes (1988) indicates that the decision to refinance should include a number of important factors: closing costs, interest rate on the existing loan, interest rate on the new loan, holding period, opportunity discount rate, income taxes, remaining balance and the term of the new loan. Auster (1998) indicates that homeowners must consider taxes, points and closing costs, and use equal amortization schedules to find the true cost savings of refinancing. He also states that when discounting the cash flows, the appropriate discount rate is the mortgage rate on the new loan. Followill and Johnson (1989) point out that because of the tax deductibility of the mortgage interest payment, the refinancing decision must be made from an after-tax perspective. They utilize a net present value model to analyze the benefits of refinancing. Bennett, Keane and Mosser (1999) indicate that the high number of loans that have been refinanced is not due to just being cost effective, but is also due to favorable economic conditions. They observe that homeowners typically refinance if the borrower's current rate exceeds the refinance rate by 50 to 200 basis points. They also find that the mortgage interest rate spread explains about 72% of the refinancing activity in the 1990-1998 period. Chen and Ling (1989) develop a model of mortgage refinancing that views the borrower as the seller of a callable mortgage bond to the lender. They find that "it is optimal, at any point in time, to refinance a fixed-rate mortgage when the present value of interest savings exceeds the refinancing costs." They also show that this minimum differential increases with transaction costs, interest rate volatility and expected holding period. Johnson and Randle (2003) present a model for analyzing the feasibility of mortgage refinancing. Their model finds the breakeven number of months between the sum of the present value of the P&I payment and unpaid balance for the old and new loans. As with previous authors, they find that it is mathematically the same to include the closing costs in the new loan balance as opposed to being "paid out of pocket. …