By Stef Donev
Contributing Editor, Interest.com
When you re shopping for a mortgage, the subject of points is likely to come up. And the most important thing to remember about "points" is that there is more than one kind.
There are three different mortgage-related definitions of point, and you must understand exactly which type of point your lender is talking about when discussing your loan. After all, you're the one who will pay the points and figure out which ones are tax-deductible.
The first definition of a point is mathematical. In the mortgage industry, a "point means 1 percent of an amount of money, explains Doug Duncan, chief economist and a senior vice president for the Mortgage Bankers Association. For example, for a $100,000 loan, one point would equal $1,000. If the loan were for $173,500, one point would be $1,735, and so on.
The term point also can refer to prepaid interest or to fees for loan-related services, or both.
Duncan explains the most common meaning of point -- often referred to as a discount point -- is simply prepaid interest. If a lender can receive part of the interest payment upfront, he or she will often lower the interest on the rest of the debt.
Most lenders will gladly trade pre-paid interest in return for a lower interest rate because no one really knows how long the loan will last. Will the buyer sell the home or refinance it in one year? In five? Few mortgages last the full 30-year term of the loan.
Let's say you took out a $100,000 mortgage today with no points at 6.75 percent for 30 years, Duncan says. If you are willing to pay one point of prepaid interest -- $1,000 up front -- the lender will lower the interest rate because you have increased the certainty of getting a return on investment -- a profit. The amount the lender would lower your rate is up to the lender.
You would not likely pay discount points if you were only planning to stay in the house only a few years. You would have to live there long enough to recoup your original output and benefit from the lower rate long enough to make it worthwhile.
This is not the only way the term point is used, Duncan adds. Sometimes lenders will characterize other expenses in the same way, as a percentage of the loan. Rather than putting a price tag on costs, such as document preparation charges, processing, underwriting and other expenses involved in getting the money, lenders often express them in terms of points.
So instead of setting a fixed price, the lender gives the charges a value as a percentage of the total borrowed, charging you two points, three-and-a-half points or more to get the loan.
The amount of paperwork doesn't change, and neither does the time spent working on the deal, but some lenders make sure the costs match the size of the loan. It is important to remember that these points have nothing to do with return on investment. They are just a convenient way for the lender to charge for the time spent drawing up the papers.
If you talk to three different lenders about what the interest rate will be and what the loan will cost, you will get three different amounts and three different uses of the word points," Duncan says. This is why it is so important to talk to more than one lender and to tell each lender what the others are offering.
When you are mortgage-hunting, let the lender know what interest rates the other lenders are charging, the points in terms of prepaid interest, and how much the points or flat-rate charges to process the loan will cost.
The number one consumer protection is shopping, Duncan says. There are no foolproof methods, but comparison shopping is the best one going.
He explains that another reason to know which points are prepaid interest and which are associated loan costs is because prepaid interest is tax-deductible, while loan-associated costs are not. Since mortgage interest payments are the single largest income tax deductions the average homeowner will ever have, it is important to know what is deductible. Deduct too many points, and the IRS could be calling on you. Deduct too few and you are throwing away money.
From the consumer's perspective, Duncan says, when you buy a house, the interest-related points are a deduction in the year the points are paid. On a refinance, however, the points you pay are deductible over the expected life of the loan, not all in one year. So if you take out a 30-year, $100,000 loan to purchase and pay one prepaid interest (or discount) point, you can deduct the full $1,000 that year. If you take out a 30-year, $100,000 refinance loan for one prepaid-interest point, however, you would be able to deduct only 1/30th of that $1,000 on your taxes every year -- $33.33.
Duncan adds that some of the points associated with getting a loan also may be deducted from your taxes, depending upon the exact nature of the expense, your own personal circumstances and where you live. Check with your tax preparer.
Buying a home is a major and complex financial arrangement, and you should make sure you understand all the details of the process -- each and every point.
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