I have a coworker who refinances her house every few years in order to keep her income taxes down. I’m no financial whiz, but it seems to me that you pay far more in interest than you save on taxes. Not to mention the costs associated with refinancing.
She and her husband have no kids and probably make between $100-200K per year. I have no idea how much they’re refinancing or what other tax shelters they have, but it just doesn’t make sense to me. All she says is that it keeps their income taxes down.
Can someone who’s money smart explain to me if there’s any advantage to what she does? To her, I mean, not to the mortgage brokers. I’ve given up talking to her about it because, well, she’s always right. Or is she?
Assuming she is periodically refinancing such that she gets fungible assets (i.e., cashes out equity), she could be putting the money to better use.
Fictional example:
Assume she has $50,000 in cash available, but chooses to buy a house for $200,000, 100% mortgaged, 6% APR. Assuming an effective tax rate of 30%, she’s only paying 4.2% on the loan. If she can earn better than 4.2% on the $50,000 cash, she’s better off taking the mortgage and leveraging that $50,000 rather than sinking it into the house. Let’s say she earns 8.2% on her $50k. She’s making $2000 a year on that $50k… and it’s compounding every year.
House then appreciates to $300,000, and she refinances again for a 100% LTV mortgage, 6% APR. Now she’s got the $50,000+EarnedInterest continuing to appreciate and another $100,000 to invest… meaning she’ll earn more than $6000 a year by cashing out that equity and leveraging it rather than leaving it “secured” in her home.
If she’s just refinancing the loan every 5 years for another 30 year mortgage for the remaining principal, then yes, she’s lowering her tax burden and lowering her payments each month, but will never pay off the loan.
She never mentioned taking out equity or making investments. All she said was every 2 or 3 years they refinance to keep their income taxes down. I also tend to think, since she’s always advising people to “sell it on EBay!!” that she’s not the savviest of investors.
She did tell me they’re closing on the latest refi today - someone just made a bunch of $$ I’m guessing…
I’m confused. If she refinances at a lower interest rate than what she had, her taxes might be going up. Equity payments over the first three years of a loan are usually fairly trivial relative to its size - and if she refinanced at the full value of the old loan at its inception, she would be getting some (but not much) cash back.
The thing is, the only way a refi will make her taxes go down is if the interest she pays goes up, right? But every dollar you itemize just reduces your taxable income by a dollar, not the taxes you owe, right? So while she may be paying less to the gov’t, she’d be ahead personally to pay higher taxes than more towards interest, right? Meaning even if she owned her house outright, the bottom line would be more money in her pocket, even with the loss of that deduction, yes?
If you have a 30 year fixed rate mortgage, every year the amount of interest you pay as a proportion of your mortgage payment goes down. Consequently, her mortgage interest deduction will go down every year. Maybe her logic is, in order to keep her mortgage interest deduction as high as possible, she always needs to keep that ratio of interest-to-principle as high as possible.
It’s just on the verge of making sense to me from that point of view, but I’m afraid I may not be using the right financial terms to describe it.
I know that when my wife and I were looking at a refi, the broker we were talking with would have been able to provide us a reduction in our 30 yr interest rate and there was enough “value” in the package that he could make money on his end to cover the costs of the refi, so it would be no cost to us.
I think you have it right, barring some weird tax-cliff situation.
Say she pays $100 in interest and her marginal tax rate is 30%. She saves $30 in taxes, so her net payment is $70.
Now, she refinances and is now paying $200 in interest (extreme example, I know). She’s now saving $60 in taxes! Win!
Uh, wait, but her overall payment is now $140. That’s an additional $70 net of taxes that she’s paying in interest to the bank. That’s not good, although her bank is happy, as is her mortgage broker, the title search company, the real estate appraiser, and the real estate lawyer.
I remember people saying that company X keeps company Y alive as a tax write-off (I think it was in the context of some company that owned an AM radio station) – it never made sense to me.
If tax rates had some sort of trigger where if you make more than a certain amount, all of your income is now taxed at a higher level, then it could make sense. But, I’m unaware of any of those things in the tax code at present.
Yes… increasing your mortgage to save on taxes is like buying stock at $100 and selling at $25. No matter how much you get back at the end, you paid a lot more at the beginning.
There’s another thing to keep in mind: the mortgage deduction is designed for original acquisition debt and debt incurred to improve the residence. In other words, if she’s refinancing to cash out equity, it’s no longer tax-deductible according to the letter of the law.
It’s reassuring to read all the answers here and know I wasn’t totally wrong about her being insane… Granted, I don’t know the specifics of her finances and there may well be an advantage and a method to her madness. But all she kept saying was they refinanced to keep their income tax deduction and save on taxes. Whatever works, I guess.
To be honest, I can’t think of a good reason for her to do this, lacking a similar risk-free asset she could invest in that would return more on an after-tax basis. And, that’s before factoring in all of the refinancing costs. Since she’s not taking any excess cash out, she definitely has no good reason to do this.
I’ve heard other people make similar arguments, but they are misinformed.
In principle, it makes little sense to me. What does she do with the money. Let’s say she puts into dividend paying stock or into coupon bonds. Then she has to pay taxes on those dividends or interest she gets. I suppose she could go for capital gains, which defers, but doesn’t eliminate them. But she had better do something with a return better than the mortgage interest and all those closing costs. Or if she is just spending it, then she is failing to create equity for eventual retirement.
The best thing I ever did financially was buy a house, pay it off, save in a retirement fund as much as I could and be in a good pension plan. I am now quite comfortably retired and can get a half million whenever I want or have to seel the house.
Her boss pays her 1. If she takes it, she has to pay .30 in tax. So she keeps $.70. Her other option is to spend it on the house’s interest, in which case she loses the $1 to the bank and gets nothing.
That’s not too bright. She probably thinks she’d rather pay the mortgage off than pay taxes, but she doesn’t realize that only interest counts as a deduction. If she keeps the interest high solely for the purpose of tax deduction, she makes no headway on the mortgage at all.
That’s not even counting the origination fee! Those are, like, 5%. That’s nuts.
She could be refinancing to pay off personal credit cards or automobiles. That would convert consumer interest (not deductable) to mortgage interest (deductable).
But, as I mentioned, that does not make the interest deductible. Following the letter of the law, mortgage interest is only deductible as original acquisition debt or when used for remodeling or major improvements. Many people do deduct interest on things like you describe and most of them get away with it, but it isn’t right.
I can’t figure out any way that she’s paying more tax deductable interest each year just by refinancing.
Paying a 5% 30-year fixed loan down for two years and then refinancing back back into a new 5% 30-year fixed gives you damn near identical mortgage interest for years 3 and 4.
Even refinacing it down to a 5% 25-year fixed after two years is neglegible.
It’s actually LESS interest.
And if you’re refinacing for a lower rate that brings down your income tax deductible interest even further.
One other option. If she is allergic to taxes, and fairly clueless, perhaps someone convinced her to do a refi (which is not insane at all these days) by telling her, incorrectly, that her taxes would go down?
My father absolutely insists in having all his investments in municipal bonds, because he hates the taxes so much. He was not interested in principal growth at all. However, after the crash, he might have had the last laugh.
Yep. I’m an official tax-talkin’ guy, and I concur with your assessment. If you gave me enough time in a quiet room with the code and regs, I could probably concoct some unlikely set of circumstances in which refinancing a house could save taxes, but absent that I’m confident that your cow-orker is nuts. People believe all kinds of crazy stuff about taxes (e.g., that it’s possible to earn $1 more than a certain threshold and actually have less after-tax cash than before earning that $1).
Muni bonds are typically priced so that they provide the same after-tax return if the income would be taxed in the second-to-highest bracket. So, if the income would be taxed in the highest bracket, the taxpayer is typically better off with the muni.
I’m no financial whiz, but it seems to me that you pay far more in interest than you save on taxes. Not to mention the costs associated with refinancing.