|Points and Home Equity Loans Deserve Close Attention|
by Benny L. Kass
A point by any other name is still a point. But whether is can be deducted on your income tax return depends on the circumstances of how and when you paid those points. And, while the interest you pay on most home equity loans is deductible, there are circumstances which could preclude your claiming these deductions. This column will address both issues:
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.
In recent months, it appears that points are not being charged by mortgage lenders as often as they have in the past. However, you want to be aware of all terms and condition before you commit yourself to a particular lender.
Points are often called by 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 $175,,000 is $1,750. Lenders can charge as many points as they want, but at some level, the loan becomes usurious, potentially illegal, and can represent what is commonly known as “loan sharking” or “predatory lending”.
Lenders have to take risks. They are loaning money to a someone 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 -- or less 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. The IRS used to require that the borrower write a separate check to the lender for these points; in recent years, however, the IRS seems to have backed away from 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, 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 $175,000. To get a favorable rate on this loan, you agree to pay one point -- or $1,750. If your loan is for 30 years, you can only deduct one-thirtieth of the points each year -- or $58.33.. However, when 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. If the purpose of the refinance loan is to pull out some money to make improvements to your house, then that portion of the points attributable to the improvement money can be deducted in the year it is paid. The balance of the points have to be spread out over the life of the loan.
Lenders are often willing to trade points for interest rates. Generally speaking, each point that you pay is roughly the equivalent of 1/8 of an interest rate. Thus, you may be able to get a loan at 6 percent with no points, but a 5 7/8 interest rate by paying 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.
If you plan to purchase a house, keep one thing in mind: 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 your example. You will pay $200,000 for your new house and obtain an 80 percent loan in the amount of $160,000. The lender can give you a fixed 30-year conventional loan for 6 percent, with no points, or 5 7/8th percent if they receive one point, or $1,600. If you can convince your seller to pay this -- and have your sales contract reflect that the seller is paying this money as points --you should be able to fully deduct this $1,600 on your income tax which you file for the year of the purchase.
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.
HOME EQUITY LOANS
A home equity loan is a second trust on your property. Many banks are prepared to lend a homeowner additional money, called a home equity loan.
Let’s take this example: the house that you purchased several years ago for $175,000 is now appraised at $200,000. Your current mortgage is $150,000. You want to pull out some cash for your personal purposes.
You have two choices: you can refinance and probably borrow up to 80 percent of the current market value of the property -- or $160,000. These funds will pay off your existing mortgage, and after paying new closing costs, you will probably walk away with approximately $9,000.
Alternatively, you can obtain a home equity loan. Here, the lender gives you a check book, which allows you to write checks up to the loan limits. Unlike a refinance loan, where you have to make monthly mortgage payments, with a home equity loan, you pay interest only on the amount of the money you have borrowed.
The tax laws allow you to deduct mortgage interest on home equity loans up to $100,000. If you are able to borrow more than $100,000, then you can only deduct the interest you pay on the first $100,000; the rest of the interest you will have to pay is considered personal and not deductible.
One day, our tax laws may be simplified. In the meantime, to make sure that you take advantage of every available deduction, read as many tax advice books that you can, search the internet -- especially the IRS website -- and consult with your own tax advisors.
(Next week: Like-Kind (Starker) Exchanges) Feel free to contact us with any questions.