Dear Dr. Don,
My wife and I have our mortgage at a 6.75% fixed rate for 30 years, but it's interest-only in the first 10 years. We have been living in the home for almost five years now. We can refinance into a new 30-year at 4.5%, which would be fully amortized, so we'd be paying principal and interest. Obviously by doing this, our mortgage interest deduction would be much lower going forward, year by year. Should I be putting this much weight on the mortgage deduction? Our household income is approximately $90,000 per year. We bought the home for $159,900, and our balance remains at $159,900.

Thanks,
-- Andy Amortize

Dear Andy,
Don't let the mortgage interest deduction on your income taxes be the tail wagging the dog when it comes to managing the financing on your family home. What you want to manage is the after-tax interest expense on your mortgage. Consider the table below:

Mortgage options

 

  Existing interest- only loan Refinancing Difference
Loan balance $159,000.00 $159,000.00 -
Interest rate 6.75% 4.5% -
Loan payment $894.38 $805.63 $88.75
Next 12 months' interest $10,732.50 $7,102.53 $3,629.97
Tax savings on mortgage interest deduction at 25% tax rate -$2,683.13 -$1,775.63 -$907.50
After-tax mortgage interest expense $8,049.38 $5,326.90 $2,722.48

Numbers may vary slightly due to rounding.

Let's assume you're in the 25% marginal federal income tax bracket, and we'll assume you can fully utilize the mortgage interest deduction (which simply means that the deduction isn't just replacing the standard deduction when you itemize expenses on your income tax return). Refinancing causes you to lose $907.50 in mortgage interest deduction over the next 12 months, but it reduces your net cost of financing over those twelve months by $2,722.48. Don't bemoan the loss of the mortgage deduction. Pocket the savings.

Your interest-only loan is going to become a fully amortizing loan with a 20-year payback five years from now. Your monthly payment will go from $894.38 to $1,208.98 -- an increase of $314.60. Get out now while rates are low and refinance that albatross of a first mortgage.

Bankrate's content, including the guidance of its advice-and-expert columns and this website, is intended only to assist you with financial decisions. The content is broad in scope and does not consider your personal financial situation. Bankrate recommends that you seek the advice of advisers who are fully aware of your individual circumstances before making any final decisions or implementing any financial strategy. Please remember that your use of this website is governed by Bankrate's Terms of Use.

Copyright 2012, Bankrate Inc.