If you refinanced in 2002, watch out for the tax hit.

• Author: Schnepper, Jeff A.
• Position: Economic Observer

SOMETIMES, you really do have to suffer the pain to get the gain. It may feel lovely to knock your mortgage rate from, say, 9% to 6%, but make sure you've planned for the tax hit. (Let's make this simple. Unless you itemize, the rest of this just doesn't apply to you. Put a big smile on your standard deduction face.)

You have now locked in the lowest interest rates in 30 years, and the difference between the rates is stuffing your pockets with dollars that would have gone to your mortgage company. Alternatively, you could be paying the same amount of dollars out of pocket and be paying off your home in fewer years. In any case, you're a big winner!

However, if you itemize your deductions, you are going to pay a price for refinancing. If you pay less, you deduct less. If you refinanced a $100,000 loan from 9% to 6%, that's a 3% difference, or approximately $3,000 that you don't get to deduct.

The earlier in the year you refinanced, the more of that $3,000 you are going to lose. Over the 12 months of 2003, you are going to lose the whole difference. (I know that the principal is reduced with each payment, so my numbers are off, but I'm trying to keep it simple so that you don't get lost in the amortization computations.)

Nevertheless, you are still way ahead, no matter how much you lose. With a top 2002 Federal tax bracket of 38.6%, a loss of $3,000 in interest deductions costs you $1,158. Since you didn't pay $3,000, you are still $1,842 ahead. Moreover, clearly you put aside at least $1,158 in cash out of the $3,000 saved to pay the additional tax--right?

Unexpected consequences

The reduction in your interest deduction may have other consequences. You only itemize if your itemized deductions exceed your standard deduction. For 2002, that's $4,700 for a single taxpayer and $7,850 for a joint return. For 2003, those numbers increase to $4,750 and $7,950, respectively. The reduced deduction may put you below those numbers. In that case, you would take the standard deduction instead.

There may be some sunshine behind the cloud. Unlike when you bought your house, any points you pay when you refinance normally are amortized over the life of the loan. This is done on a monthly basis. So, say you refinanced a $100,000 loan for 20 years at a cost of three points, or 3%. That $3,000 would be divided by the loan term--240 months--for a $12.50-per-month deduction. If you took out the loan on July 1, you would have six months, or a deduction of $75...