Closing Costs When Refinancing: How to Account for Them Properly
Understand how to properly account for refinancing closing costs, from lender fees to tax treatment, and their impact on financial statements.
Refinancing a mortgage can lower interest rates or improve loan terms, but it also comes with closing costs that must be accounted for. These fees can add up quickly, reducing the financial benefits if not managed properly. Understanding how to handle these costs ensures they don’t erode potential savings and helps with tax planning and financial reporting.
Types of Refinancing Closing Costs
Refinancing involves various fees, many of which are similar to those in a home purchase. Loan origination fees, typically 0.5% to 1% of the loan amount, cover the lender’s processing costs. Some lenders waive this fee in exchange for a higher interest rate.
Lenders also require an updated appraisal to verify the home’s value. Appraisal fees usually range from $300 to $600, though some lenders waive them for borrowers with strong credit and sufficient equity.
Title-related costs include a title search to confirm ownership and title insurance to protect against claims. These fees vary by loan size and state regulations, often costing several hundred to over a thousand dollars.
Recording fees, charged by local governments to update mortgage records, range from $25 to $250. Borrowers may also need to prepay property taxes and homeowners insurance into an escrow account.
How Lenders Determine These Fees
Lenders calculate closing costs based on factors like credit score, loan amount, and risk level. Borrowers with higher credit scores typically pay lower fees, while those with lower scores may face additional charges.
Loan-to-value (LTV) ratio also affects costs. Borrowers with less equity generally face higher fees to offset lender risk. Those with at least 20% equity often receive better terms.
Market conditions influence fees as well. When refinancing demand is high, lenders may raise origination and administrative costs. During slow periods, they may reduce fees or offer incentives.
State regulations and lender policies further impact costs. Some states impose additional recording fees, while others cap certain charges. Large lenders may have standardized pricing, while smaller institutions or credit unions may offer more flexibility.
Tax Treatment of Specific Charges
The IRS classifies refinancing costs differently, affecting their tax treatment. Some expenses are deductible, while others must be capitalized and amortized.
Mortgage interest and real estate taxes may be deductible in the year paid. Prepaid interest, such as per diem interest covering the gap between closing and the next mortgage cycle, can be deducted if the taxpayer itemizes. Property taxes paid at closing are also deductible if based on the home’s assessed value.
Certain fees, such as underwriting, processing, document preparation, credit reports, and notary services, are not deductible since they are considered service costs rather than interest expenses.
For rental properties, tax treatment differs. Nondeductible costs for a primary residence, such as loan origination fees and legal expenses, can be added to the property’s cost basis and depreciated over time. This allows landlords to recover these costs gradually through depreciation under the Modified Accelerated Cost Recovery System (MACRS).
Accounting for Points and Amortized Costs
Loan discount points, prepaid interest paid to lower the mortgage rate, must be amortized over the loan’s term. If a borrower pays $3,000 in points on a 15-year refinance, the annual deduction would be $200 ($3,000 ÷ 15 years), assuming no early payoff or refinancing event alters the schedule.
Other closing costs, such as legal fees and mortgage broker commissions, must also be amortized. Under Generally Accepted Accounting Principles (GAAP), these costs are recorded as assets and expensed over the loan’s duration using the straight-line or effective interest rate method. The effective interest rate method provides a more precise allocation, adjusting for the declining principal balance over time.
Recording Refinancing Costs in Financial Statements
Properly recording refinancing costs ensures accurate financial reporting. These costs must be classified appropriately to reflect their impact on cash flow, net income, and liabilities.
For personal residences, most refinancing costs are capitalized and amortized over the loan term. Loan origination fees, title insurance, and legal expenses are recorded as deferred costs on the balance sheet and gradually expensed. If a homeowner refinances multiple times, unamortized costs from a previous refinance must be written off when the loan is paid off early.
For businesses and real estate investors, refinancing costs are typically recorded as financing expenses or capitalized as part of the asset’s cost basis. Under GAAP, these costs are amortized over the loan’s life. If a business refinances at a lower interest rate, the remaining balance of previous refinancing costs must be written off as an expense in that period. Prepayment penalties incurred during refinancing are also recognized as an immediate expense, affecting net income. Proper classification ensures compliance with financial reporting standards and provides a clear picture of the company’s financial position.