Illinois loan mortgage refinance

Falling interest rates have motivated many people to refinance a current mortgage or buy a new home. Before applying for a loan, however, borrowers should determine whether a fixed-rate or an adjustable-rate mortgage would best meet their needs. If they choose a fixed-rate mortgage, borrowers also need to choose the term of their loan.

Adjustable-Rate Mortgages

Adjustable-rate mortgages (ARMs) typically have a lower initial interest rate. The interest rate on an ARM is tied to one of two independent indexes: U.S. Treasury securities or the cost that banks pay to borrow funds. A margin of 2 to 3 percent is added to the index rate to determine the mortgage rate for the "adjustment period," the period of time for which that rate will be used to calculate the interest costs. Because large swings in the index rate can cause substantial changes in the monthly mortgage payment, "caps" typically are placed on any increase or decrease that may occur during an adjustment period.

Fixed-Rate Mortgages

Borrowers who want to lock in mortgage costs by using a fixed-rate mortgage need to consider the benefits and the disadvantages of both 15-year and 30-year fixed-rate mortgages.

The 15-year mortgage. The advantages of a 15-year mortgage include retiring mortgage debt more quickly and paying less interest. A 15-year mortgage usually has a lower interest rate, typically 25 to 50 basis points lower, than a 30-year mortgage. For example, compare a 30-year loan at 7 percent with a 15-year loan at 6.6 percent. On a $250,000 loan, the interest payments would total $348,769 over 30 years, but only $144,476 over 15 years, saving the borrower more than $200,000 in interest payments.

An evaluation of the two types of loans should include a comparison of the after-tax cost of making interest payments. Home mortgage interest can be a significant tax deduction. This deduction is available to all taxpayers regardless of their income bracket, provided that they itemize their deductions.

In general, interest paid to buy, build, or substantially improve a personal residence is deductible if the debt is secured by the property and does not exceed $1.1 million. In the aforementioned example, if a person were in a combined Federal and state income-tax bracket of 40 percent, the after-tax interest savings of the 15-year mortgage over the 30-year mortgage would be reduced to $122,576.

The 30-year mortgage. Although the 30-year mortgage will cost more in interest, even after tax deductions, this option still can be advantageous because the 30-year mortgage will have lower monthly payments than a 15-year mortgage. That advantage may be important from a current cash-flow perspective, particularly if the excess monthly cash available is invested properly.

Using the $250,000 loan amount, the monthly payment on a 30-year mortgage is only $1,663 compared with $2,191 for a 15-year mortgage. The difference is $528, but because a greater portion of the 30-year payment would be tax-deductible interest, the after-tax differential on the two mortgages for the initial monthly payment is $562. The after-tax difference increases as the interest portion of the 15-year loan declines relative to the interest portion of the 30-year loan payment.

A borrower can invest the after-tax difference on a regular basis. Depending on the performance of one's investments, a person could find that taking the 30-year loan and investing the excess allows one to accumulate more wealth over the long term. Be aware that investment returns are not a sure thing and that the pattern of returns earned on the excess fund is important. Earning a high rate of return after the excess fund has grown in value is better than enjoying a high rate of return when the excess fund is small. A person can calculate the average rate of return that is needed over the long term to make this a successful strategy.

Evaluating Choices

To project which strategy would provide the best benefit, a borrower will need to make some assumptions. The first assumption for the aforementioned example is that the borrower invests in a diversified portfolio that generates a pretax yield (interest and dividends) of 2 percent per year. The next assumption is that the borrower will have combined Federal and state ordinary and capital-gain tax rates of 40 percent and 24 percent, respectively and that there will be a 25 percent portfolio turnover rate.

Under those assumptions, a borrower's portfolio would need to average a pretax annual growth rate of more than 4 percent over 30 years to benefit financially from the 30-year mortgage. If a person could obtain an 8 percent average growth rate, choosing the 30-year mortgage instead of a 15-year mortgage could result in an increase in wealth of more than $227,000.

Conclusion

Choosing the most appropriate mortgage should be based on both financial and nonfinancial factors.

A 15-year mortgage may be the best option for a person who:

* Likes a disciplined saving program;

* Is a conservative investor;

* Has paid his or her current mortgage down and does not want to assume a new 30-year debt; and

* Expects to move again in the not-too-distant future.

A 30-year mortgage may be the best option for a person who:

* Would have to limit contributions to 401(k) or similar plans due to the higher payments needed under the 15-year mortgage. These plans, which offer an immediate tax offset, tax-deferred growth, and often a substantial employer match, may be the best use for excess funds.

* Believes he or she can get a substantially higher return on investment assets than what will be needed to break even.

* Is concerned about income fluctuation and ability to make the higher monthly payments required under a 15-year mortgage.

Choosing the right mortgage strategy will depend on both the accuracy of the borrower's projections and his or her specific needs.

William G. Kistner, MM, CPA, is a tax partner. Ernst & Young LLP, Chicago, Illinois, and a member of HFMA's First Illinois Chapter.