Mortgage Basics - What are points?
by Benny L. Kass
When you are shopping for a mortgage loan – whether it be for a purchase of a house or a refinance -- do not rely only on the interest rate quoted by the lender. Make sure that you ask whether there are any points which will have to be paid at settlement.
Points are often called different names -- such as loan discounts or origination fees -- but regardless of their name, they represent money which you -- the homeowner -- will be required to pay in order to get your mortgage loan. And the payment is usually up-front, in cash, at settlement.
Each point that you pay is equal to one percent of the mortgage loan amount. Thus, one point on a loan of $180,000 is $1,800. Lenders can charge as many points as they want, but at some level, the loan becomes usurious, potentially illegal, and may represent what is commonly known as "loan sharking".
Lenders have to take risks. They are loaning money to a stranger, who may or may not be able to pay the loan in full. To secure repayment of the loan, the lender requires the borrower to sign a deed of trust (the mortgage document) whereby the house is put up as collateral (security) to guarantee full payment of the loan. But houses can (and have) decreased in value, which makes the lender's security potentially more risky.
The higher the risk, the higher the mortgage interest will be; the higher the risk, the more points a lender will want to charge. But many consumers do not shop around to get the best mortgage deal; they accept the lender's statements on blind faith. It may be possible to get a better interest rate -- are fewer points -- from another lending source.
Points paid on a mortgage to buy a house (or to pay for improvements you are making to the property) are fully deductible in the year they are paid by the borrower. It used to be that the IRS required that the borrower write a separate check to the lender for these points; in recent years, the IRS seems to have backed off of this position. However, it still makes sense to either write a separate check at closing -- or at least have the settlement statement (the HUD-1) clearly reflect the number and amount of points you are paying.
If you pay points to obtain a refinance loan, generally they are not deductible in full for the year they are paid. Rather, the IRS requires that you allocate the points by the number of years of your mortgage loan. For example, you refinance and obtain a loan in the amount of $225,000. To get this new loan, you are required to pay two points -- or $4,500. If your loan is for 30 years, you can only deduct one-thirtieth of the points each year -- or $150. However, if you pay off this loan early -- say in five years -- the balance of the unallocated (nondeducted) points can then be deducted on your income tax return for that year.
Lenders are often willing to trade off points for interest rates. Generally speaking, each point that you pay is the equivalent of 1/8 of an interest rate over 30 years. Thus, you may be able to get a loan at 7-1/2 percent with no points, but a 7-3/8 interest rate with one point.
If you plan to keep the loan for a long time, it might make sense to pay that point (or points) up front. But first you should "do the numbers" to determine where the break-even point will be. To do this, compare the monthly payment for both interest rates. Take the difference between these two rates and divide that number into the amount of points you pay. The result is the number of months it will take you to break even -- after which you are ahead of the game.
Let's take this example. Say the difference between the two interest rates is $150 per month, and you have to pay $4500 in points to get the lower rate. $4500 divided by 150 equals 30; thus, in 30 months (or 2.5 years) you will break even. After that period of time, you will start saving $150 per month in your mortgage payment.
Is it worth it? Only you can decide, since $4500 is a lot of money to pay up front.
Everything in real estate is negotiable. Often, a potential buyer submits a sales contract to a seller, and asks the seller to make certain financial concessions in order to make the sale go through. Such concessions include (1) the seller giving a cash credit at settlement, (2) the seller paying some or all of the buyer's closing costs, or (3) the seller paying some or all of the buyer's points.
For many years, the Internal Revenue Service did not allow seller-paid points to be deducted by the purchaser. In a complete about-face, however, on March 28, l994, the IRS ruled that these points can now be deducted by the purchaser.
The Service announced that for principal residences purchased after December 31, 1990, purchasers could deduct, under certain circumstances, points required by mortgage lenders, even if those points were paid by the seller. This is generally referred to as "seller-paid points."
Let us look at an example. You will pay $275,000 for your new house and obtain an 80 percent loan in the amount of $220,000. The lender can give you a fixed 30-year conventional loan for 7 ½ percent, with no points, or 7-1/4 percent if they receive 2 points, or $4,400. If you can convince your seller to pay this $4,400 -- and have your sales contract reflect that the seller is paying this money as points --you should be able to fully deduct this $4,400 from your income tax which you file for this year.
The most recent pronouncement by the Internal Revenue Service -- spelled out in Revenue Procedure 94-27 -- now permits the buyer to deduct all of the points paid. However, there are some qualifications. According to the IRS, the points must be clearly spelled out as points on the HUD-1a settlement statement. Additionally:
- They must be calculated as a percentage of the principal loan amount; it cannot be just a round number;
- They must actually be paid to acquire the taxpayer's residence, and the loan must be secured by that residence. In other words, there must be a Deed of Trust (the mortgage document) securing the specific property, and
- The points charged by the lender must be consistent with the number of points generally charged in the area in which the residence is located. In other words, if a lender were to charge you 12 points (which has happened on occasion), 9 or 10 of the points will probably not be deductible.
Taxpayers are reminded that the settlement sheet is perhaps the most important document received at settlement, and should be kept forever. This will be your best proof if you are ever challenged by the IRS.
There is one additional aspect which homeowners must understand. If your seller pays your points, that amount will be used to reduce the purchaser's basis if the purchaser deducts those seller- paid points.
In our example, if the purchaser paid $275,000 for the property, and now deducts $4,400 of seller-paid points, the cost basis to the purchaser is reduced by the amount of the points deducted. In our example, the basis of the house for tax purposes will now be $271,000 ($275,000 minus $4,400).
Here, however, the new tax law may come into play. Under the Taxpayer Relief Act of l997, taxpayers can fully exclude from taxable income up to $250,000 of gain ($500,000 for married couples filing a joint return) on the sale of their principal residence. This exclusion can be taken once every two years; the once-in-a-lifetime exclusion has been eliminated from the law.
Thus, under the new law, the taxpayer's tax basis of his/her principal residence is relatively unimportant -- unless the taxpayer makes a profit that exceeds the statutory dollar amounts of $250,000 or $500,000. In our example, if you sell your house several years later for $450,000, your gain of $179,000 -- even taking into consideration the $4,400 reduction in basis -- will still be less than $250,000 ($450,000 less $271,000 equals $179,000). Under the Taxpayer Relief Act of l997, if you have lived in this home for at least two years, all of your profit is tax-free.