Divorce is a tumultuous life event, and when intertwined with financial decisions such as refinancing, it can add a layer of intricacy to an already complex situation. Typically, individuals refinance their homes to secure lower interest rates and reduce costs, but there are circumstances in which higher interest rates may be a strategic choice during a divorce. In this article, we’ll explore the potential benefits and drawbacks of opting for refinancing with higher interest rates and underline the necessity of consulting with financial professionals during these uncertain times.
The Advantages of Refinancing with Higher Interest Rates
Refinancing with higher interest rates may seem counterintuitive, but there are situations where this approach can be advantageous.
- Immediate Financial Relief: If you find yourself grappling with exorbitant monthly mortgage or loan payments amid a divorce, refinancing at a higher interest rate, even with a larger loan, can offer much-needed respite in monthly payments. This can be especially valuable if you require a lump sum of cash for various divorce-related expenses, including attorney fees or the equitable division of assets.
- Short-Term Requirements: If you anticipate selling your property or paying off the loan within a relatively short timeframe, opting for a higher interest rate may not significantly impact your overall interest payments. Many individuals choose to refinance at higher rates with the expectation of refinancing again when interest rates decrease or before putting their home on the market for sale.
- Tax Benefits: Historically low-interest rates and tax changes (increased standard deductions) have caused many individuals to not qualify for the mortgage interest deduction through itemization. However, higher interest rates could allow you to itemize this expense, potentially mitigating the actual impact of the higher interest rate. Consulting with a financial professional can help determine the after-tax or ‘effective’ interest rate.
- Divorce Benefits: Refinancing can safeguard your financial independence in a divorce by separating your finances from your ex-spouse. Maintaining a joint mortgage post-divorce can entail credit risks and complicate estate planning. It’s generally recommended to untangle financial ties as much as possible for a smoother transition and a healthier co-parenting relationship. For instance, in Colorado, joint rights of survivorship will automatically cease after a divorce, transferring ownership to ‘tenancy in common.’ If the non-resident spouse remarries and passes away while still co-owning the property, the ex-spouse and the new spouse would share ownership of the property.
- Income Tax Bracket Consideration: Higher interest rate refinancing may be advantageous for individuals in higher tax brackets where tax deductions hold more value. Conversely, it may not be as beneficial for those in lower tax brackets or those primarily receiving tax-free alimony and child support.
- Lump Sum Maintenance Payout Could Become Deductible Again: A home with significant equity could provide a lump sum maintenance payout to the non-resident spouse. The resident spouse paying spousal support is essentially trading in a non-deductible monthly spousal support payment (spousal support became a non-taxable transfer due to the TCJA in 2019) for a larger tax deductible mortgage payment that pays out the receiving spouse with a lump sum cash payment.
The Drawbacks of Refinancing with Higher Interest Rates
Despite the potential advantages, there are several drawbacks to consider when refinancing at higher interest rates.
- Long-Term Costs: The most glaring downside of refinancing at a higher interest rate is the increased interest payments over the life of the loan. Although monthly payments could be lower (if extending the term of the loan), the total interest paid throughout the loan’s duration can be considerably higher.
- Qualification Challenges: Higher interest rates can pose challenges for individuals seeking to qualify for a new home loan due to factors like income limitations, debt burdens, or loan-to-value ratios. Given the complexities of divorce and shifting financial circumstances, meeting the criteria for a higher interest rate can be a formidable challenge.
- Reduced Home Equity: Refinancing at a higher interest rate results in slower home equity growth compared to a lower interest rate, potentially affecting long-term financial stability and the ability to tap into home equity for other purposes.
- Credit Impact: Difficulties in making on-time payments due to increased monthly obligations from a higher interest rate could negatively impact your financial situation should unplanned financial events occur such as job loss, disability, etc.
While refinancing with higher interest rates is not the conventional choice due to the potential for increased long-term costs and reduced financial benefits, it’s crucial to evaluate your unique financial situation and objectives thoroughly, especially during a divorce when asset ownership becomes more intricate. Seeking guidance from a financial professional can help you model various scenarios, taking into account variables such as tax benefits, financial goals, and budget constraints, empowering you to make well-informed decisions about refinancing. Don’t hesitate to reach out to us for assistance during this challenging phase.