When it comes to comparing interest rates for a real estate
mortgage loan, homebuyers often have the option of choosing a loan with a lower interest
rate by paying points. Simply put, a point is equal to 1 percent of the loan amount. For
example, with a $100,000 real estate loan, one point equals $1,000. Points are usually
paid out-of-pocket by the buyer at closing.
Paying points may seem attractive, because a lower interest rate means smaller monthly
payments. But is paying points always a good idea? The answer generally depends on how
long you plan to keep the real estate in question. Here's an example:
Joe and Tammy Jones are shopping for loan rates on a $150,000 home. Their bank has offered
them a 30 year loan at 7.5 percent with no points. This works out to a monthly payment of
$1,049.
However, their bank has also offered them a loan at 7 percent if they agree to pay 2
points (or $3,000). At this lower rate, their monthly payment drops to $998, or a savings
of $51 per month.
By dividing the amount they paid for the points ($3,000) by the monthly savings ($51), we
see that they will have to own the house for 59 months (or just under 5 years) before they
will start to see savings as a result of paying points. If Bob and Betty plan to stay in
the house for many years, then paying points could make good sense. But if they see
themselves moving to another house in the near future, they'd be better off paying the
higher interest and no points. (Note: for simplicity, the above example does not take into
account the time value of money, which would slightly lengthen the break-even time.)
Can you deduct points on your income taxes?
In the United States, one side benefit of paying points on a real estate mortgage loan is
that they are fully tax deductible for the same tax year as your closing. However, this
does not apply to points paid for a refinance loan. For refinances, the IRS requires you
to spread out the deduction over the life of the loan. For example, if you paid $5,000 in
points for a 30-year refinance loan, you can only deduct 1/30 of the $5,000 each year for
30 years. If you pay off the loan early, though, you can deduct the remaining amount that
tax year.
Leveraging Your Money
One of the greatest financial aspects of buying a home is the ability to leverage your
money. leverage allows you to use a small down payment and financing to purchase a larger
investment. For example, if you bought a $125,000 home with 10 percent down, you leveraged
the $12,500 down payment to purchase an asset worth 10 times that amount!
Appreciation
The benefits of leverage really become apparent with appreciation, or the rise in value of
a property. Using the above example, say you live in the house for 5 years, and during
that time property values in your area had rise an average of 2.5 percent a year. Your
home would then be worth over $141,000. By putting only 10 percent down, you enjoy the
appreciation for the full amount!
Paying yourself
In addition to the 10 percent down, you'll also have to make mortgage payments. But with
each payment, a certain amount of money is being used to pay down the principal balance
that you owe. This is called building equity. So in the event you sell your house, not
only can you realize a profit from your leveraged money, you also have a chance to pay
yourself back for the money you've put in over the years. |