(Ed Note: This post originally ran in May, but as the debt ceiling debate raged and taxes became the forefront of discussion, we felt that this perspective was worthy of running again.)
There really is no such thing as a refinance tax, but this comes from the “I didn’t think of it like that” category. As many CPA’s like to point out, the government does not have to raise tax rates to actually increase tax revenue. All they have to do is eliminate a tax deduction you were previously enjoying, and voila, you pay more taxes even when your tax bracket remains the same.
Well, if you are deducting the interest you pay on your mortgage and have been taking advantage of the low interest rates by refinancing, chance are your tax bill will be a bit larger than in years past.
Here is why (this example has been simplified, but you’ll get the point):
Step 1 – You refinance your $300,000 mortgage from 6.25% to 5.00%. A savings of 1.25% on $300,000 is $3,750/year! And, let’s say you lower your monthly mortgage payment by $345/month (or $4,140/year). Not bad!
Step 2 – The previous year, on your 6.25% mortgage, you paid roughly $18,750 in interest which you deducted from your $100,000/year income. This deduction saved you approximately $4,700 in tax – assuming a 25% marginal tax rate.
Step 3 – Now, with your refinance complete, you enjoy a lower annual interest expense of $15,000/year. Assuming, again, no changes to your income, deductibility or tax bracket, the deduction would still save you approximately $3,750 in tax.
Step 4 - However, if you now look at your year-over-year change you will note that in Step 3, your deduction was $3,750 less than the previous year. This results in you paying $950 more in tax, because you refinanced.
OK, so at the end of the day you would still net a positive cash flow of about $265/month, which still warrants the refinance – both good and smart for your family. But, here is where I think the numbers begin to get really interesting…
1. Under the example I provided above, for every 1 million households who refinance, the IRS will collect about an additional $1 billion in tax revenue!
2. If the average refinance saves a household $150/month, for every 1 million households that is an extra $150 million “spend-able or save-able” circulating in our economy every month ($1.8 billion a year). And if it’s getting spent it’s getting taxed and driving more revenue for the US.
A billion dollars of additional revenue to the IRS may not sound like much, but then remember, you only needed $100,000/year to borrow $300,000 from the bank. And, when the US government can generate an additional $50 billion in revenue it easy to see how they justify racking up more debt. When we start putting multiples to these numbers, it’s easy to see how we are funding a part of our own recovery (read: issuance of massive amount of Treasury debt) by refinancing.
Furthermore, the road to recovery is through consumer spending which accounts for about 66% of our Gross Domestic Product (GDP). And, when households use their additional cash flow from refinancing to buy new tires for the car and go out to dinner – these events help to create and support jobs. When consumers are safe in their employment the economy expands.
Obviously our economic recovery is much more complex, but hopefully now you’ll have a greater appreciation of how all the little things begin to build up.
Guest Author Dirk Walker, CMPS® is with Affiliated Financial Group has been a loan originator for 17 years and is a Certified Mortgage Planning Specialist.
He can be found online at http://www.DirkWalker.com.
