Refinancing Mortgages Bethel Park PA
Bethel Park, PA
Upper St Clair, PA
Bethel Park, PA
The loan-origination fee is often the largest expense a borrower incurs. This fee is considered up-front interest on the loan. A point equals 1 percent of the principal of the loan. For example, three points on a $100,000 mortgage would equal $3,000. Points are part of the lender's profit and are generally considered together with the interest rate. The two are usually related: The higher the rate, the lower the points; and the lower the rate, the higher the points. For each point paid, a borrower can typically reduce their mortgage rate by one-quarter of 1 percent (.25 percent). Therefore, by prepaying interest in the amount of one point (1 percent of the loan amount), a borrower might be able to reduce the mortgage rate from 5.25 percent to 5 percent. When the points cover more than the origination fee, the additional points are called discount points, which serve to offset the interest rate. Sometimes you can pay discount points up-front at closing to get a lower interest rate on your mortgage. As a result, it may take you three or four years - or more - before your interest savings cover all of the loan costs. This may still be a good option if you are planning to keep your home for a number of years.
Often, the points and other closing costs associated with a purchase or refinancing can be included as part of the total loan package. Lenders charge points for a variety of reasons, primarily to provide the lender with immediate income. Lenders also sometimes offer no-cost refinancing, charging you no points for your mortgage. Usually, you will pay a higher interest rate on a zero-point or no-point mortgage than on an otherwise comparable mortgage with points. When a borrower pays points, he or she is prepaying interest that may be deductible on his or her tax return. A borrower can deduct points in the year they are paid, if all of the following apply:
the loan is used to acquire or improve the borrower's primary home.
the loan is secured by the home.
the points are calculated as a percentage of the loan amount.
the HUD Settlement Statement refers to the points paid as loan-origination fees, loan discount, discount points or points.
the amount charged as points is an accepted business practice in the locality where the borrower purchases the home. Points may be deducted on the borrower's tax return as long as the points represent interest expense to the borrower and are not disguised service charges. If the loan does not meet all of these requirements, a borrower cannot deduct all the points in the year they are paid. The tax law does not allow a borrower to deduct all of the points paid for refinancing a loan during the year they are paid. The tax law requires the points to be deducted ratably over the life of the loan. This is in keeping with the position that points paid to refinance an existing home mortgage are costs of repaying the borrower's indebtedness and are not paid in connection with the purchase or improvement of the home. The tax law makes this distinction - it is not a matter of logic. By ratably, the IRS means deducted in equal amounts over the life of the loan. In addition, points paid to buy a second home, take out a home equity loan, or refinance a mortgage must be deducted monthly over the life of the loan. Even with the payment of points, borrowers who buy their homes late in the year may not have enough deductions to itemize on their tax return in the year of purchase. Such borrowers can salvage some benefit from the payment of points by electing on their tax return for the year of purchase to deduct the points monthly over the life of the loan. They will not benefit in the year of purchase, but they will on future tax returns. Since there is usually a trade-off between a lower interest rate with points and a higher rate without points, the IRS position on points complicates the decision of whether or not to pay points.
Factors to Consider When evaluating the decision to pay points, many borrowers perform a simple analysis. They divide the up-front cost of the points by the reduction in their monthly payment to calculate a break-even period, which is the number of months required to recoup payment of the points. For example, if Tom and Mary borrow $150,000 at 6.25 percent in a 30-year mortgage, they will have a monthly principal and interest payment on their mortgage of $924. By paying one point, $1,500 ($150,000 x 1 percent), they can reduce their interest rate to 6 percent and lower their monthly payment to $899. Dividing the $1,500 in points by the $25-per-month reduction in principal-and-interest payment leads to the conclusion that they will recover the additional amount paid in points in 60 months. Missing Factors This analysis is correct as far as it goes, but it does not take into consideration the following factors:
Points are tax deductible either immediately or over the life of the loan.
The reduction in monthly mortgage payments also reduces the borrower's tax deduction for mortgage interest.
For any given month, the mortgage payoff is different because the amount of principal being paid each month is not the same under the two options.
A borrower could invest the $1,500 used to pay the points and earn a return.
The cash flows for the two options have to be adjusted for the time value of money. Even some of the most popular Internet-based mortgage calculators fail to consider all of these factors. In order to perform the correct analysis, a customized spreadsheet has to be constructed. The appropriate way to calculate the break-even point is to consider the cash flows from the two different financing options. You will need the help of your accountant to perform such an analysis. Conclusions The longer you stay in a home, the higher the investment rate of return needed to break even. Most people should not pay points if they expect to be in a home for less than six years.
There is a negative association between the contract rate of interest and the number of points paid. However, that association is statistically significant only for fixed-rate loans. It appears that paying points does not yield a lower interest rate on an adjustable-rate loan. By paying points, the borrower saves the difference in interest payments each month, and he or she gets the yearly tax write-off of the points. However, the borrower does not get to take the increased interest expense deduction associated with the higher rate. If the loan is paid off before its maturity, the points that have not yet been deducted can be written off completely at that time. For a specific situation, the appropriate numbers can be calculated, but you will need help from your accountant. An increase in the tax rate lowers the rate of return, as does a decrease in the life of the loan. However, an increase in the interest rate increases the rate of return. When considering investment rates of return, the timing of the tax deduction from paying points, and the time value of money, the break-even point (in months) is usually longer than suggested by considering only the reduction-in-payment approach shown above. If a borrower can earn a 6 to 7 percent rate of return or higher, it does not make sense to pay points when the points cannot be deducted immediately, unless the borrower plans to be in the house at least nine to 10 years. Thus, borrowers should think twice before paying points when they refinance, buy a second home or take out a home equity loan. Several factors, including mortgage rate, length of ownership, and whether the points are deductible immediately or over the life of the loan affect the payback period. The most important factor, however, is the investment returns available to the borrower. Most borrowers should carefully consider their investment alternatives and their time horizon before paying points. Milton Zall is president of Zall Enterprises, an editorial consulting firm based in Silver Spring, Md. He is a certified internal auditor and registered investment advisor. He can be reached at email@example.com.