What are Mortgage Points?
Points are prepaid interest on the mortgage loan. Often referred to as "discount points", each point is equal to one percent of the amount of the mortgage loan. For example, if a loan is for $25,000, one point is equal to $250. If a mortgage loan is 100,000, one point is equal to $1,000. What is the purpose of points? They are charged by a lender to raise the yield on his loan at a time when money is tight, interest rates are high, or there is a legal limit on the interest rate that can be charged on a mortgage. Points reduce the interest rate on the mortgage loan by requiring prepayment of a small percentage of the total interest due. The number of points owed is up to your lender. For instance, a one point loan will always have a lower interest rate than a no point loan. Each point equals 1% of the total loan amount. Note that with conventional loans, points can be paid by either the borrower or the seller or each can agree to pay half; however, borrowers are prohibited from paying points on HUD or Veterans' Administration guaranteed loans.
A rule of thumb regarding points is that the longer you plan to keep the house, the more points you can afford to pay. By keeping the house for at least four years, you will recoup the costs of the points by paying lower monthly payments.
Note that points are tax deductible if you pay for them up front and if you do not already own a home. You can deduct the entire cost of points in the year of closing. If you are buying a second home, you must spread out the deduction over the term of the mortgage.
Why Pay Mortgage Points for Your Loan?
Points are dollars you pay as a percentage of your loan. A common use for points is to secure a lower interest rate on your loan. By paying a little bit up front, points allow you to pay less each month. A point is one percent of the mortgage loan amount. To use easy numbers, let's assume that your loan will be for $100,000. In that case, one point would be $1,000 (100,000 x .01 = 1,000). While shopping loan rates, you may find that different loans are available with and without points. You might pay anywhere from zero to three points. In our example, that means you'd pay anywhere from $0 to $3,000 up front. The best way to decide whether you should pay points or not is to perform a break-even analysis. This is done as follows:
- Calculate the cost of the points. Example: 2 points on a $100,000 loan is $2,000.
- Calculate the monthly savings on the loan as a result of obtaining a lower interest rate. Example: $50 per month.
- Divide the cost of the points by the monthly savings to come up with the number of months to break even. In the above example, this number is 40 months. If you plan to keep the house for longer than the break-even number of months, then it makes sense to pay points; otherwise it does not.
- The above calculation does not take into account the tax advantages of points. When you are buying a house the points you pay are tax-deductible, so you realize some savings immediately. On the other hand, when you get a lower payment, your tax deduction reduces! This makes it a little difficult to calculate the break-even time taking taxes into account. In the case of a purchase, taxes definitely reduce the break-even time. However, in the case of a refinance, the points are NOT tax-deductible, but have to be amortized over the life of the loan. This results in few tax benefits or none at all, so there is little or no effect on the time to break even.
Points on a refinance are not deductible in the same way. On a refinance you normally have to spread your deduction out over the amortization of your loan (check with your tax advisor). If you are tight on funds for closing opting for a loan with the lowest upfront cost and no discount points may cost may be right for you. Over the life of the loan you may be paying out more money however enabling you to provide for your families immediate needs.
Are Mortgage Points Tax-Deductible or Does It Make Sense to Buy Mortgage Points?
If at any time in your life you have ever taken the mortgage then you are well aware of tax advantages that you can get by deducting your mortgage interest payments. In some cases the points can also help you to save tax bills for those who refinanced or got an equity or line of credit. Mortgage points come in two varieties Origination points and discount points. Each point is 1% of the loan amount. So if you have a loan amount of $100,000 then one point equals to 1% which is $1,000.
Lenders mainly charge points as a way to make profits while borrowers on the other hand pay points in exchange for lower mortgage rates. If you paid points then the amount should be listed on the 1098 statement from the lender. The document also make the entries of how much mortgage interest you paid and both these deductible amounts go on line 10 of the schedule A.
Generally you cannot deduct the full amount of the mortgage points in the year paid as they are considered as the prepaid interest and must be deducted equally through the life of the loan but with some exceptions. On a conventional mortgage which is usually a fixed rate 30 year loan points may be paid either by the buyer or seller or split between them. So exactly how much of one and depends on the circumstances of the loan.
Are discount points worth paying?
As you know each point costs 1% of the mortgage amount so the more points you pay the lower will be your mortgage rate. It is up to you to decide more points and a lower rate or fewer points and higher rate. For all this consider few points
- How long will you keep this home?
- Whether you can afford to make the upfront payment now for the points.
- The duration of the time you expect to have the mortgage because the longer the mortgage you have it makes more sense to pay the points now because you will have a long time to benefit from the lower rate.
- Do you have extra cash in hand to buy points?
Loan points are fully deductible in the year paid if they meet the following requirements
- The loan must be secured by your main home where you live most of the time
- Paying points must be an established practice in your area
- Points paid were not more than generally charged in that particular area
- You can go for the cash method of accounting like most of the individuals as you report income in the year you receive it and deduct expanses in the year you pay them
- You cannot pay points in exchange for lower or no appraisal fee title fee, inspection fee etc
- The loan must be used to buy or build your main home
- The points must be computed as a percentage of principal from your mortgage