Q: We will retire in a few years and hope to build our retirement home now while we are still in the earning stage, and a new loan will give us a tax shelter in the interim. We have been advised to have our current home refinanced to give us money for building the new one. Since loans are difficult to obtain in today's economy, refinancing appears an attractive alternative. What do you suggest?
A: Because interest rates have been so high for so long, this column has not discussed refinancing recently. However, your question, combined with a variety of new mortgage alternatives gives me an opportunty to go back to a favorite concept--refinancing.
For those of us who remember the "good old days," when the value of houses was escalating rapidly, refinancing was a very common tool to pull out the unused equity in your house and put that money to better purposes. Obviously, when interest rates were 16 to 17 percent, most of us did not want to even consider the concept--even if we were able to afford it.
Let's give an example of refinancing. A few years ago, perhaps in 1976, you purchased a house for $70,000. You put down $20,000 and obtained a mortgage for $50,000 at a rate which you then considered exorbitant, such as 9 1/2 percent. Your monthly payments for principal and interest were approximately $420.
Your house is now worth about $150,000. Your mortgage is down to about $45,000. You're sitting with approximately $105,000 of equity, which in this market is really dead money.
Your mortage lender probaby would like to get rid of that low 9 1/2 percent mortage.
The mortgage industry has been quite concerned about the drain on its funds. And, if they can increase their yield, they will be willing to give you what is known as a "blended rate." Such a rate means that the lender will charge you an interest rate blended between the old 9 1/2 percent rate and the current rate, which is still over 15 percent. With luck, your lender may be willing to give you a new loan at 13 percent.
Let's look further at the refinancing potential. If your house is worth about $150,000, your lender probably will be willing to make a new loan of $100,000. The blended rate may be 13 percent, which means that your monthly mortage payment (principal and interest) will be $1,106.20.
Clearly, you have to be able to afford this new payment, which is about $680 per month higher than your old schedule of payments. However, there are tax benefits to keep in mind. If you analyze the year-end financial statement your mortgage lender sends you, you probably will notice that the interest payments on your old loan are beginning to decrease. Under the new loan, at least for the first few years, the great bulk of the monthly mortage payment will be interest, which is deductible.
Under my example, if you borrow $100,000 at 13 percent, the average interest per month is $1,083.33. If you are in a 40 percent tax bracket, you will get a $433.33 deduction per month.
Tax advice can only be general because the actual saving depends on your personal financial situation. However, the concept is applicable generally; and your real cost is considerably lower when you plug in the interest tax deductions.
Following through on this example, you will see the following cash benefits:
* Refinanced loan of $100,000
* Pay off old mortgage of $45,000
* Balance is $55,000
* Minus $3,000 for points.
* Minus $1,500 for closing costs
* Total net to you is $50,500
When you refinance, for all practical purposes, it is the same as if you ware going to a new settlement. There are points to be paid to the lender. (A point is one percent of the loan, and in this example you may have to pay as much as three points, or $3,000.) You also will have settlement costs, such as a new title search, a new survey and perhaps some recordation charges. In my example, I have included $1,500 for these extra items.
But the bottom line is that you will pull out of your house approximately $50,500. Keep in mind that this is your own money, since you are using your own equity. There is no taxable consequence when you refinance. Thus, you will not have to pay any tax on the $50,000.
I hope this new money will be sufficient to help you build that retirement home. I assume you have already made inquiries as to what it will cost you to borrow that $50,000 elsewhere, and I strongly suspect that it will cost more than the 13 percent which we have used in this example.
Refinancing our equity is a concept that appears to be coming back. As interest rates are dipping and as many new kinds of financing arrangements become available, those of you who want to "tap your equity" should give serious thought to this idea.
One significant caution: We cannot predict the future. If you have any concern about your ability to make these higher payments -- now or in the future -- stay away from refinancing. You do not want to get caught in the "creative financing syndrome" in which many homeowners now find themselves. Their monthly payments are just too high for them to live comfortably.