June 29, 2018
June 29, 2018
If you have taken a mortgage in the past, you’re probably aware of mortgage points. If you’re about to take your first mortgage, you need to understand what these fees are. They will likely come up at some point in the mortgage process, and it’s best to be prepared for them in advance.
Mortgage points are fees collected by a mortgage lender, typically in payment of two types of expenses that are connected with the mortgage lending process. We will discuss each in some detail in the next two sections.
The term “points” comes from the fact that each mortgage point represents 1% of the mortgage loan amount or one point. Thus if a loan comes with 2 points, and your loan amount is $200,000, you will pay $4,000 – $200,000 X 2% – in points upon the closing of the loan.
Lenders often charge points as a form of compensation for their services. This is typically referred to as origination fees and generally does not exceed one point or 1% of the loan amount.
This represents the lender’s compensation for arranging the mortgage and is considered one of the closing costs that will appear on your mortgage closing statement.
Many borrowers mistakenly believe that the lender is somehow compensated for their services through the loan itself. But since each mortgage is effectively sold off as a bond (or more specifically, as part of a pool of loans in a bond), the direct lender is actually acting as an agent in arranging the loan. They will, therefore, charge a closing fee – an origination fee – that will represent their income on the loan.
Some lenders will charge a full point, while others may charge something less, such as half a point (0.50%) or three-quarters (0.75%). It all depends upon what the common practice is in your area, and how competitive the lender is trying to be.
Mortgage points can also be charged as a way of lowering your interest rate. Within the mortgage industry, this is referred to as a mortgage buydown, or permanent buydown, because the points charged on the loan are used to buydown the interest rate that the borrower will pay for the life of the loan.
In the current interest rate environment, one point can be used to buy down the interest rate on a 30-year mortgage by about 1/8 of 1% (0.125%). In this way, you may pay two discount points (2% of the loan amount) to lower the interest rate from 4.25% to 4.00%, enabling you to get the benefit of the lower interest rate throughout the term of the loan.
Considering that each mortgage point represents 1% of the loan amount, it’s undeniable that paying points is expensive! However, there are a couple of strategies that can enable you to pay the points without having to come up with additional cash at the closing table.
Here are two of those strategies:
Seller paid closing costs. This is where a property seller pays some or all of your closing costs, including points. The seller will do this as an inducement for you to buy his or her property. It is only permitted by lenders in areas were seller paid closing costs are common.
The closing costs must also be reasonable based on the general market. But if it is is common in your area, the seller may offer to pay something like 2% or 3% of the property sale price for your closing costs. Other times, they may offer to pay a flat amount, such as $5,000. However it works out, any points that you are required to pay will be covered by the seller.
Lender paid closing costs. If the seller doesn’t pay any closing costs, you can set up your mortgage in such a way that the lender will pay your closing costs for you.
Within the mortgage industry, lender paid closing costs are often referred to as premium pricing. “Premium” because the lender will be charging you a slightly higher interest rate to pay your closing costs and points. That means that technically speaking, it isn’t really the lender who pays your closing costs, but you, through a slightly higher interest rate.
In the previous section, we talked about how the conversion rate to lower your interest rate on a permanent basis works out to be 1% to produce an interest rate that is lower by 1/8 of 1%. Premium pricing or lender paid closing costs works in the same way – but in reverse.
For example, let’s say that your closing costs will be 2% of your new mortgage amount. The seller will not pay for your closing costs, and you don’t want to come up with the extra cash out pocket.
Instead, you ask for the lender to pay the closing costs. To cover the entire 2% of closing costs and points, the lender increases your interest rate by a quarter percent (0.250%) over the life of the loan. So if the going rate on a mortgage is 4.25%, you agree to accept 4.50%, so that the lender will cover 2% toward your closing costs and points.
If you do pay points on your new mortgage, you may be able to take a tax deduction for them – unless they are paid by lender paid closing costs.
The amount of the points that you have paid can be deducted on Schedule A of your IRS Form 1040 if you are able to itemize deductions. You will receive a 1098 statement from the mortgage lender, that will report mortgage interest paid. But in the year that you take a new mortgage, they will also report the payment of points in a separate box. The points will be reported as a dollar amount. You should also be able to find the points listed on the closing statement on your mortgage if they are not broken out on the 1098.
According to IRS regulations, and regarding purchasing a new home, you can deduct the points in full in the year you pay them if you meet all the following requirements:
- Your main home secures your loan (your main home is the one you live in most of the time).
- Paying points is an established business practice in the area where the loan was made.
- The points paid weren’t more than the amount generally charged in that area.
- You use the cash method of accounting. This means you report income in the year you receive it and deduct expenses in the year you pay them.
- The points paid weren’t for items that are usually listed separately on the settlement sheet such as appraisal fees, inspection fees, title fees, attorney fees, and property taxes.
- The funds you provided at or before closing, including any points the seller paid, were at least as much as the points charged. You can’t have borrowed the funds from your lender or mortgage broker in order to pay the points.
- You use your loan to buy or build your main home.
- The points were computed as a percentage of the principal amount of the mortgage, and
- The amount shows clearly as points on your settlement statement.
If you pay points in connection with a refinance, the amount paid must generally be deducted over the life of the loan. For example, if you pay 1 point on a $300,000 mortgage, which is equal to $3,000, and the new loan is a refinance for a 30 year term, you can deduct $100 ($3,000 divided by 30 years) per year on Schedule A – along with any other mortgage interest that you paid during the year.
And in a nice twist, if you refinance your property again, the remaining balance of points paid on the original refinance can be deducted fully in the year when the second refinance is done. So if you deducted $100 per year for five years ($500 total), but did another refinance after the fifth year of the loan, the remaining $2,500 of points paid on the original refinance, will be deductible in the year in which you complete the second refinance.
Mortgage points can be a big expense, but as you can see, there are ways to get around paying them, and even tax benefits in the process.