Pay discount points on a mortgage, and you’re taking a gamble.
Plenty of borrowers lost that wager in recent years, according to the Kitsap Sun and a pair of economists. According to Yan Chang and Abdullah Yavas, who set out to describe consumers’ behavior, say you should think hard before you pay discount points, and if you do, don’t hesitate to refinance.
Chang and Yavas concluded that home loan applicants tend to pay points because they overestimate how long they’ll keep their home loans. Furthermore, people who pay discount points tend to wait too long to refinance.
Paying discount points is a way of reducing the mortgage’s interest rate. One point is 1 percent of the loan amount. On a 30-year, fixed-rate loan, one point (which is sometimes called an origination fee) typically reduces the rate by one-quarter of 1 percent.
If you can borrow $200,000 at 6.25 percent with zero points, you could borrow the same amount at 6 percent by paying one point, or $2,000.
That would save $32.33 a month. It would take 62 months (more than five years) to break even - for accumulated monthly savings to total the $2,000 paid upfront.
Of those surveyed who pay points:
- Two-thirds had paid off their home mortgage by June 2005, either because they sold the house, applied for a mortgage refinance or defaulted on the loan. Of those people, 1.4 percent benefited by paying mortgage points.
- One-third still had the original mortgage in June 2005, the cutoff date. Of those people, 16 percent already had benefited from paying points by June 2005, and the percentage probably grew higher as time passed.
To summarize: At least two-thirds of the points payers made the wrong bet. Most of the non-points payers made the right call.
That might sound like a slam-dunk against paying mortgage points. It’s not, because mortgage rates were falling and home values were rising during much of the study period, creating many opportunities for mortgage refinancing.
“Personally, I think that it is a caveat of this study that it covers a period typified by historically low mortgage rates and increasing house prices, which offers borrowers more incentive to refinance than times of rising interest rates, where more borrowers might reap the full benefits of mortgage points,” Chang said.
Chang adds that she’s describing how people act, not prescribing what they should do with their mortgage loan. She says her paper makes the point that “the decision process of the borrowers is more complicated than our model can capture.”
“What we could measure,” she adds, “and what the economic theories use as the basis of analysis, are the monetary incentives - gains or losses in dollar terms - but what we can’t observe are the hidden motives.”
“Some borrowers may consider time spent entertaining their families is more valuable than watching the rise and fall of the rates, and therefore choose to pay points because they wish to lock in on a low rate so they don’t have to spend time watching out for cash out refinancing opportunities.”
Bottom line: Borrowers make choices based on their own needs and goals, and in some cases paying points works in their favor. But be sure this is true in your case before you jump the gun. When in doubt, use a mortgage calculator or talk to a professional.
Posted by Richard Barber on Feb 02 2007 under Points
If you have ever taken out a mortgage, you probably already know the tax advantage provided by deducting your payments on your home mortgage rate.
But - as Bankrate.com tells us - many homeowners overlook another tax break available for points paid to get a home loan. In some cases, points also could shave tax bills for folks who refinanced or got a home equity loan or line of credit.
Each point is 1 percent of the loan amount. Lenders charge points as a way to make a profit, while borrowers generally pay points in exchange for lower mortgage rates.
If you paid points, the amount should be listed on the 1098 statement from your lender. This document also notes how much mortgage interest you paid. Both of these deductible amounts go on line 10 of Schedule A. (If the points aren’t on that statement, but show up elsewhere - for example, on your closing documents - enter them on line 12. Check the Schedule A instructions for details.)
Getting the maximum deduction
On a conventional mortgage, points may be paid by either buyer or seller or split between them. Even if the seller pays all the points, the buyer gets the tax deduction. Exactly how much of one and when depends on the loan circumstances.
Loan points are fully deductible in the year paid if they meet all these requirements:
- The home loan is secured by your main residence, the house you live in most of the time.
- Paying points is an established business practice in your area.
- The points are generally what is charged in your region.
- You use the cash method of accounting: You report income in the year you receive it and deduct expenses in the year you pay them. Most individuals do this.
- The points are not paid in place of amounts ordinarily stated separately on the settlement sheet. That is, you cannot pay points in exchange for lower or no appraisal fees, inspection fees, title fees, attorney fees and property taxes.
- The funds you come up with at or before closing, plus any points the seller pays, must be at least as much as the points charged. The money does not have to apply just to the points. It can include a down payment, escrow deposit or earnest money. But it all must come to at least as much as the points.
For example, you took out a $100,000 mortgage and were charged $1,000 (one point). However, your lender only required a $750 down payment. In this case, you cannot deduct the full $1,000 points payment, only $750 of it. The remaining $250 must be deducted over the life of the loan. And you cannot have borrowed any of the money you paid at closing from your lender or mortgage broker.
- The loan is used to buy or build your main home.
- The points are computed as a percentage of your mortgage’s principal amount.
- The amount is clearly shown on the settlement statement as points charged for the mortgage. The points may be shown as paid from either buyer or seller funds.
“But it’s deductible!”
How often have you heard that from people, especially when they talk about mortgages? And more importantly, the Washington Post asks, what does it mean for you?
Let’s say you plan to purchase a condominium for $300,000 and put $30,000 (10 percent) as a down payment. You will need a $270,000 mortgage loan.
One lender has offered you a fixed-rate 30-year mortgage at 6.25 percent, with a monthly payment of $1,662.45. Another lender is trying to persuade you to take an adjustable-rate mortgage that will stay fixed for three years at 5.5 percent interest. The monthly mortgage payment for the first three years will be $1,533.04.
You analyze the numbers and see that there is a difference of $129.41 per month between each mortgage loan. But that’s not the end of your inquiry. You know that you are in the 25 percent income tax bracket, meaning that you are married and jointly you earn between $61,301-123,700.
That means that for every dollar you pay in home mortgage interest, you can deduct 25 cents on your tax return. So when you plug in these deductions, the difference between the two mortgages drops to $97.06 a month.
You should ask yourself whether the monthly saving of $97.06 for the three-year ARM is really worth it, taking into account that the payment on that home loan could jump considerably if mortgage rates are higher when it is recalculated in three years.
The deductibility of mortgage interest is one of the big breaks the tax code gives to homeowners, as well as points paid. Here’s a look at how deductions operate:
Mortgage interest: Interest on a 1st or 2nd mortgage is fully deductible, subject to the following limitations: acquisition loans may total up to $1 million, and home equity loans may total $100,000. If you are married but file separately, the limits are split in half.
For debt to qualify as an acquisition loan, you must buy or substantially improve your home with that money. If you apply for a home loan refinancing for more than the outstanding indebtedness, the excess amount does not qualify as an acquisition loan unless you use it to improve your home.
For example, let’s say your current home mortgage balance is down to $200,000, but because of the tremendous appreciation over the past few years, your house is now worth $600,000. You want to refinance and get some money.
Based on your credit and the equity in your house, your lender is prepared to lend you $450,000. That sounds great, but unless you use the money to improve the house, you will be able to deduct interest on only $300,000 - acquisition debt of $200,000 plus $100,000 in home equity.
Points: When you shop for a mortgage - which is something every potential home buyer should do - you get a lot of data thrown at you. One of the most important items you should understand is the concept of “points.”
Each point is 1 percent of the amount of your mortgage loan; you pay points upfront when you borrow. Points sometimes go by other names, such as loan discounts or origination fees. But for tax purposes, they’re points.
If you were to borrow $450,000, each point would cost you $4,500. Lenders can charge as many points as they want, but at some level, a loan becomes usurious, potentially illegal, and may represent what is commonly known as “loan sharking.”
Typically, for every point you pay a mortgage company, you should be able to reduce your interest rate by 1/8 of a percent. Because rates were extremely low in the past few years, borrowers generally have not wanted to pay extra cash just to get an even lower rate.
Points paid to obtain a new mortgage are fully deductible in the year they are paid by the borrower. The IRS used to require that the borrower write a separate check to the lender for these points; in recent years, the IRS seems to have backed off this position.
If you pay points to obtain a loan for conventional mortgage or home equity loan refinancing, in most circumstances those points are not deductible in full in the year they are paid. Rather, the IRS requires that you allocate the points by the number of years of your loan.
For example, you refinance and obtain a loan for $450,000. To get this new loan at a reduced interest rate, you opt to pay one point, or $4,500. If your loan is for 30 years, you can deduct one-thirtieth of the point each year, or $150.
However, should you pay off this loan early, either by selling the house or refinancing again, the balance of the unallocated (non-deducted) points can then be deducted on your income tax return for that year.
You should not pay points.
So reported a study we relayed to readers a few weeks ago. But is this always valid? After all, an offer to pay more now in order to pay less later may be attractive to some borrowers. According to The Wall Street Journal Online, there’s evidence that people often make the wrong choice.
Lenders frequently let borrowers pay points to lower the home mortgage rate on their loan. Each point costs one percent of the mortgage amount; you pay up front (or roll the points into the loan and pay over time). In return, the loan’s interest rate drops permanently, often from one-eighth to one-quarter of a percentage point for every point paid.
Points were popular in the 1970s, when interest rates were high. As rates have fallen to historic lows recently, however, fewer people have bothered. Buying points can still make sense, however, if you play the numbers right.
Start with a basic question: How long do you think you will possess the home loan? If you hold it long enough, the savings on the monthly payments from the lower interest rate will more than cover the cost of the points. Most of the time, it takes years to get there.
Doing the math involves other issues, too, such as whether you intend to invest any savings with the money not spent on points. Plus, there are tax breaks for points buyers. You can use a mortgage calculator to figure this all out.
Let’s say you seek a $500,000, 30-year, fixed-rate mortgage and can get a 6% rate with one point or a 6.25% rate with no points. You would have to keep that loan for 57 months to break even on the points (assuming you are in the 33% tax bracket and your savings earn 7%).
To see how points have worked out for borrowers, Penn State professor Abdullah Yavas and one of his graduate students, Yan Chang - who is now a senior economist at mortgage giant Freddie Mac - tracked 3,785 fixed-rate mortgages between 1996 and 2003.
The researchers obtained their data from Freddie, but the company didn’t fund the research or assist in any other way, said Mr. Yavas.
The pair found that just 1.4% of borrowers held their home mortgages long enough to break even on the points they paid. The rest paid off their loans more than three years, on average, before they would have hit that break-even point.
How could so many people get it wrong? Interest rates fell during the period, and home values rose, so those who sought a mortgage refinancing had good reason to seek a new deal.
However, that highlights the risk in paying points in the first place: No one can predict which way interest rates are headed. That said, rates remain low, which means that people currently paying points are somewhat less likely to need to refinance later just to obtain a lower rate.
If you hold the loan for a decade or more, paying points can pay off big time. But throwing thousands of dollars at them doesn’t seem wise, given our proven inability to predict the future.
That is the question.
And more often than not, the answer is NO.
A new report claims that borrowers tend to purchase too many points when selecting a mortgage - and in the process end up paying more than they would have with no points and higher mortgage rates.
The study was co-authored by Abdullah Yavas, Professor of Business Administration at Penn State’s Smeal College of Business, and Yan Chang of Freddie Mac, and is reported today by Business Week.
The two considered 3,785 individual mortgages originated from 1996-2003, looking at the points paid, interest rates and the average loan term.
Data showed that those who buy points are overestimating the amount of time they will hold their home loans. They tend to pay off their mortgages about 37.5 months too early for the purchase of points to actually pay off - defaulting, moving or refinancing before hitting a break-even point so the strategy made sense.
- By purchasing points, borrowers lower the rate on the mortgage. One point, or origination fee, is equal to 1 percent of the mortgage, and charged as prepaid interest.
- Points that you pay to purchase your primary residence are deductible in the year you pay them on your federal income-tax return; points you pay to refinance must be written off over the life of your mortgage.
“We underestimate the possibility that we may refinance in the near future - or refinance again in the near future - and the possibility that we may have to move, either for job relocation or other reasons,” Yavas said.
The numbers tell a surprising story. A tiny 1.4 percent of borrowers who purchased points held their first or second mortgage loans enough to make it pay off; of those who didn’t buy points, only 1.5 percent would have been better off purchasing them, according to the study.
However, the researchers are quick to point out that the data covers a time of lower interest rates and increased property values, leading to plenty of refinancing activity.
The report also found that borrowers who buy points often don’t treat them as costs they can never recover and so are less likely to refinance. When they do, they often do it late, perhaps hoping to compensate for the points.
If a borrower went ahead and “paid too many points and the rates come down quickly, refinancing right away would be the same as accepting the fact that you shouldn’t have paid those points,” Yavas said.
Yavas took an interest in the topic after he decided to refinance his own home a few years back and considered the trade-off between points and interest rates. Like mortgage prepayments, this is a subject that is hotly debated, but one for which little research of this caliber has been produced.
Posted by Richard Barber on Dec 26 2006 under Points
