Did you ever stop to analyze the difference in monthly payments between different interest rate mortgages?
Everyone wants to get the lowest rate mortgage possible. Hopefully, they shop around, contact different mortgage lenders and try to negotiate for the best terms.
But do they really do the numbers? Do they look at the actual monthly payment which each loan will require?
For example, what do you think is better for a $200,000 loan: a 6 percent interest rate with one point or a 6 1/8 rate with no points? Keep in mind that a point is one percent of the amount loan -- or in our example $2,000.
The monthly payment to amortize a $200,000 loan over 30 years at 6 percent will cost you $1199.11. This is only for principal and interest; we are not including taxes and insurance in this example. The monthly payment for that same loan at 6 1/8 percent will be $1215.23 -- or $16.12 more a month.
But in order to get that lower rate, you will have to pay the lender the one point in the amount of $2,000. It will take you almost 124 months (over 10 years) in order to break even and being to reap the benefits of that lower rate. ($2,000 ÷ 16.12 = 124.07 months).
In this example, I am not taking into consideration the tax deductible consequences of the higher interest rate as compared to the ability to deduct the point.
How long do you plan to stay in your new home? Do you have better use for the $2,000 than merely to pay it to a mortgage lender so as to give you a slightly lower mortgage interest rate?
These are all questions which potential homebuyers should consider when shopping for a mortgage.
The tax considerations should also be carefully reviewed. The interest you pay on a mortgage is generally deductible when you file your annual 1040 income tax return.
Let's look at two aspects of this deduction:
Mortgage Interest:
Interest on mortgage loans on a first or second home is fully deductible, subject to the following limitations: acquisition loans up to $1 million, and home equity loans up to $100,000. If you are married, but file separately, the limits are split in half.
You must understand the concept of an acquisition loan. To qualify for such a loan, you must buy, construct or substantially improve your home. If you refinance for more than the outstanding indebtedness, the excess amount does not qualify as an acquisition loan unless you use all of the excess to improve your home.
Let us look at this example: Several years ago, you purchased your house for $200,000 and obtained a mortgage (or deed of trust) in the amount of $150,000. Your mortgage indebtedness is now reduced to $125,000, but your house -- having received the benefits of recent inflation -- is worth $400,000.
Because rates were low last year, you refinanced and were able to get a new mortgage of $210,000. Your acquisition indebtedness is $125,000. The additional $85,000 that you took out of your equity does not qualify as acquisition indebtedness, but since it is under $100,000, it qualifies as a home equity loan.
The Internal Revenue Service has made it clear that one does not have to take out a separate home equity loan to qualify for this aspect of the tax deduction. However, if you would have borrowed $250,000, you would only be able to deduct interest on $225,000 of your loan -- the $125,000 acquisition indebtedness, plus the $100,000 home equity.
The remaining interest is treated as personal interest, and unfortunately is not deductible.
Points:
When you shop for a mortgage loan -- which is something every potential homebuyer should do -- you will be given a lot of information. One item which you must understand is the concept of "points."
Points are often disguised with different names -- such as loan discounts or origination fees -- but regardless of their name, they represent money which you -- the consumer -- must pay. And the payment is usually up-front, in cash, since it generally is not included in the loan amount.
One point is equal to one percent of the mortgage loan amount. Thus, one point on a loan of $225,000 will cost you $2,250. 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 take risks. They lend money to a stranger, who may or may not be able to re-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 despite the recent -- and almost unbelievable appreciation in the past few years -- 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 take the lender's statements about credit status on blind faith. It is often possible to get a better interest rate -- or less points -- from another lending source.
Points paid to obtain a new mortgage are fully deductible in the year they are paid by the borrower. The IRS originally 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, however, in most circumstances those points 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 $210,000. To get this new loan, you are required to pay two points -- or $4,200. If your loan is for 30 years, you can only deduct one-thirtieth of the points each year -- or $140.00. However, should you pay off this loan early -- say in five years either by selling your house or refinancing again -- the balance of the unallocated (nondeducted) points can then be deducted on your income tax return for that year.
Talk to your potential lenders about trading interest rates for points. Generally speaking, each point that you pay is the equivalent of 1/8 of an interest rate. Thus, you may be able to get a loan at 5.625 percent with no points, but a 5.5 percent loan rate with one point.
Seller-paid points:
Everything in real estate is negotiable. Often, a potential buyer presents 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:
* the seller paying some or all of the buyer's closing costs;
* the seller giving a cash credit at settlement; or
* the seller paying some or all of the buyer's points.
Believe it or not, the IRS has issued a ruling that these points can be deducted by the purchaser. The Service announced that purchasers can 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 your example. You will pay $250,000 for your new house and obtain a loan of $200,000. The lender can give you a fixed 30-year conventional loan for 5 3/4 percent, with no points, or 5 1/2 percent if they receive 2 points, or $4,000. If you can convince your seller to pay this $4,000 -- and have your sales contract reflect that the seller is paying this money as points --you should be able to fully deduct this $4,000 from your income tax which you file for this year.
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 major hitch to deducting seller-paid points. The amount of the points paid by the seller will be used to reduce the purchaser's basis if the purchaser now deducts those seller-paid points. In our example, if the purchaser paid $250,000 for the property, and now deducts the $4,000 of seller- paid points, the cost basis to the purchaser is reduced by the amount of the points deducted. In our example, the basis will now be $246,000 ($250,000 minus $4,000).
Here, however, the current tax law will come into play. As has been discussed earlier in this series of articles, 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.
Thus, the tax basis of 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 $400,000, your gain of $154,000 -- even taking into consideration the $4,000 reduction in basis -- will still be less than $250,000 ($400,000 less $246,000 equals $154,000). If you have lived in this home for at least two years, all of your profit is tax-free.
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