Whenever interest rates begin or are expected to change significantly, individuals immediately begin to think of refinancing their existing mortgage. That is a good approach to take. However, there are other considerations to ponder before going to the mortgage company and applying for a refinancing.
Mortgage lenders want to verify that you have sufficient income to service the debt. Standard industry practice is to request to see your individual income tax returns for the last 2-3 years. If you are self-employed, that means the lender also wants to see the tax returns for your business. If you are a sole proprietor, your personal tax return will suffice because the income and expenses of your business are reported on Sch. C of Form 1040, your personal income tax return. However, if your business is in the form of an S Corporation or partnership, the lender will also ask to see those returns (Form 1120S and Form 1065, respectively).
Lenders can often be difficult to work with if you do not have W-2 income. Sole proprietors and partners in partnerships do not receive W-2 income as the IRS rules forbid them to be treated as an employee. S Corp. employee/shareholders are required to receive W-2s, but often the W-2 income is only a small percentage of their income from the business. Thus, these non-traditional W-2 persons create more work for the lender as to how to verify the loan applicant’s income, and this often results in more requests for documentation from the lender. Lenders will often request that the taxpayer’s CPA verify the income from the business or the viability of the business. These letters are often referred to as “comfort letters”. CPAs are bound by the State Board of Accountancy and professional and ethical standards. Failure to follow these rules can result in the CPA losing his/her license. Unless a CPA has performed an attest examination of the business, the CPA cannot ethically provide the lender with the verification that is being requested. Lenders know this, but unfortunately some attempt to strong-arm the applicant and CPA. If you wish to learn more about comfort letters, we suggest you read The Comfort Letter Trap.
What should you do if you are considering a refinance?
- First, if you have any unfiled tax returns, have your tax professional prepare these returns so that you can timely provide the lender with the returns when requested. Even if you do not refinance, it is always a good idea to make sure that you are current with your tax compliance.
- Second, have your accountant prepare what is called a break-even point analysis to show how long it will take for your savings to be greater than your closing costs. This is particularly of value if you have a job that requires frequent relocations or you expect to retire in a few years and will be relocating. In other words, you need to make sure you’re in your current home long enough to recover the refinancing charges.
- Third, consider the length of the mortgage note when refinancing. Most persons automatically take the shorter loan because it is often at a lower interest rate. That may not always be the most prudent decision. If you have the ability to pay off your loan in 15 or 20 years, you may want to consider taking a 20 or 30 year note. You can usually pre-pay your mortgage debt without penalty, so the interest savings of a shorter note are not always significant. The advantage of a longer note is that if finances become tight due to a job layoff or illness, the longer note allows you to pay less money each month to keep your mortgage current while having extra funds available to meet those emergencies.
- Fourth, get out your crystal ball and see where interest rates are headed for in the future. For instance, those individuals with adjustable-rate mortgages will find them more expensive if interest rates rise in the future and perhaps now is the time to lock in a fixed-rate mortgage.
If you want to discuss your business or personal tax planning, tax preparation and other financial concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.