Refinancing Your Mortgage: Faster than a Tax Cut
January 16, 2001

Refinancing Your Mortgage: Faster than a Tax Cut

Long before the new Congress will discuss any tax cut legislation an economic rescue is working its way through the markets. Already, only days after the Federal Reserve cut the discount rate, home mortgage interest rates have dropped to levels not seen in at least two years.

The evidence is abundant. You can find it in tables of mortgage offerings in the daily newspaper. You can visit any number of websites that specialize in mortgage finance. Either way, home mortgage rates are now well under 7 percent. In the last few days I have seen offers of 30-year conventional mortgages (under $275,000) at 6.5 percent with no points. Some institutions are offering 15-year mortgages at 6.25 percent, with no points.

Rates this low will induce some homeowners to refinance. Still lower rates, which may be in the offing, could produce a flood of mortgage refinance very much like we had in 1993.

The immediate reason this is important is obvious. Every dollar not spent on mortgage interest is a dollar that is available to save, invest, or spend elsewhere. Lower mortgage rates are the next best thing to free money.

Something less obvious, however, may be more important.

For most Americans, lower interest rates are more powerful than tax cuts.

You can understand this by considering the position of an imaginary family, the Malls. The Malls have an income of $60,000 a year and live in a house now worth about $150,000. Purchased several years ago, the house is mortgaged for $120,000 at an interest rate of 7.5 percent. The mortgage payment, excluding taxes and insurance, is $839 a month.

When they do their tax return for the year 2000 the Malls will have a $9,000 itemized deduction for mortgage interest and a $3,000 deduction for real estate taxes, a total of $12,000. After considering the benefit of their deductions, the Quicken Tax Planner calculates their federal income tax bill to be $5,520. It also tells us that their marginal tax rate is 15 percent.

With mortgage rates sinking, the Malls start shopping. While they might refinance from 7.5 percent to 6.5 percent, refinancing is more likely to be a good "investment" for them if the interest rate reduction is larger. So let's imagine that mortgage rates decline a bit further.

With a little luck, they refinance at 6 percent and emerge from the refinancing with a monthly payment of $719. This means their monthly payment has dropped by $120 and they have $1,440 a year more than they had before the refinancing.

One ironic by-product is that their Federal income tax bill will rise. With about $1,800 a year less in interest deductions, their income tax would rise to $5,790, a $270 increase. So they have netted $1,170 a year on the process, nearly $100 a month.

Now compare this to their pre-refinancing federal income tax bill of $5,520. The net money available to them is the equivalent of a 21 percent tax cut--- significantly more than they are likely to get from any tax cut that might be passed.

Are 6 percent mortgage rates a pipe dream?

I don't think so.

With the consumer price index rising at a 3.4 percent annual rate and the producer price index rising at a 3.7 percent annual rate, long Treasuries could be selling at historically normal returns at 5.6 to 5.9 percent. This assumes that bonds yield 2.2 percent premium over the rate of inflation, the long-term relationship found in the Ibbotson Associates data. Since these inflation figures include food and energy, two volatile components of prices, some would make a case for still lower interest rates.

The only problem? This economic boon isn't for everyone--- you have to be a homeowner with a mortgage to benefit. Then again, most tax cuts aren't for everyone and lower mortgage rates offer a broad benefit that doesn't require the blessing of Republicans or Democrats.

Bottom line: start gathering your application information. Refinancing may be your patriotic duty.

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