We are in a refinance boom. Mortgage interest rates are now at their all time low, and homeowners all over this country are taking advantage of these low rates by refinancing their existing home mortgage.
In the midst of this boom, the Internal Revenue Service has just issued a press release (IR-2002-114) reminding taxpayers that some of their refinancing costs may be deductible. According to the IRS, while points paid to obtain a refinance mortgage are generally not deductible in the year they are paid, “if part of the refinanced mortgage money was used to finance improvements to the home and if the taxpayer meets certain other requirements, the points associated with the home improvements may be fully deductible in the year the points were paid.”
First, let’s define “points”. When you apply for a mortgage, your lender will present you with a number of options. You can get a fixed 30 year mortgage, or a fixed 15 year mortgage. You can get an adjustable rate mortgage (ARM), where the interest stays fixed for a certain period of time (1, 3 or 5 years), and thereafter adjusts yearly based on a somewhat complicated formula.
Oversimplified, the shorter the term of the loan, the lower the mortgage interest rate will be. Thus, a one year ARM should command a much lower interest rate than a fixed 30. Prospective homeowners should understand that “there is no free lunch”. While a one year ARM sounds very attractive, over the years it could command an interest rate considerably higher than the fixed 30.
In addition to rate quotes, mortgage lenders also will offer to reduce your mortgage interest if you pay points. Each point is the equivalent of one-eighth of an interest rate. Thus, you may be able to get a fixed 30 at 6 3/8 for no points, but if you pay one point, your rate may be 6 2/8 (6.25 percent).
There is, of course, a catch to this: points are calculated on the face amount of the loan, with each point being one percentage of the loan amount. Thus, if you borrow $250,000, and you opt to pay one point, you will have to pay $2,500 up front at closing. Depending on your circumstances, this may be a lot of unnecessary money to pay for the privilege of getting a slightly lower interest rate loan.
Let’s look at the numbers: you want to borrow $250,000, and being conservative, you opt for a fixed 30 year mortgage.. At 6 3/8, your monthly mortgage (principal and interest) will be $1,559.68. If you pay one point (i.e. $2500) and get a 6.25 loan, your monthly payment will be $1539.30 – or $20.38 less each month.
But you have now spent $2500 to save $20.38. Is it worth it? It will take you over 10 years before the interest rate savings start to kick in ($2500 divided by $20.38). Will you stay in the house for the next ten years? Do you have something better to do with the $2500 than give it up front to your mortgage lender? And what about the tax benefits when you pay this point? If this is a loan to purchase a home, the point will be fully deductible in the year it is paid. But even if you are in the top bracket (i.e.38.6), you can only deduct that percentage of the points which you have paid.
On the other hand, if you refinance and pay points, you can only deduct these points over the life of the loan. According to the IRS reminder: For a refinanced mortgage, the interest deduction for points is determined by dividing the points paid by the number of payments to be made over the life of the loan. Usually, this information is available from lenders. Taxpayers may deduct points only for those payments made in the tax year. For example, a homeowner who paid $2000 in points and who would make 360 payments on a 30-year mortgage could deduct $5.56 per monthly payment, or a total of $66.72 if he or she made 12 payments in one year.
However, if you are refinancing again – as has been the case with a lot of homeowners in recent years – the unused portion of the points from your previous loan should be fully deductible when you pay off that older mortgage loan.
Thus, if you are planning to refinance your existing mortgage anytime in the near future, you must do your homework. Do comparison shopping – not only with several lenders but also with several different kinds of loans. Get a rate sheet from the lenders you talk with, so that you can sit down in the comfort and privacy of your home to analyze which loan is best suited for you. Also, you should inquire whether there is a pre-payment penalty associated with your existing loan – as well as with any future loan you plan to obtain. Many lenders, recognizing that homeowners may refinance again within a short period of time, will attempt to impose a stiff pre-payment penalty, especially on adjustable rate mortgages. Clearly, the existence of such a penalty can be a significant deterrent to your refinancing plans.
There is some very helpful information on the IRS website. Go to www.IRS.gov, and then Frequently Asked Questions (keyword: financing fees). Additionally, the IRS has published several helpful documents and they can either be located on the IRS website or ordered directly from the IRS by calling 1 - 800 829 3676. These documents are Publication 936, “Home Mortgage Interest Deduction”; Publication 523, “Selling your Home”; Publication 527, “Residential Rental Property”, and Publication 530, “Tax Information for First-Time Homebuyers”.