Mortgage discount points now tossed in one basket

“What’s a point?” the caller asked on our radio show. “My lender says I have to pay one to get the rate I want. Do they come with all mortgages?”

Points are a pain.

They are difficult to explain to the first-time homebuyer, sometimes an added expense for the seller, a tender bargaining spot for agents and a mandatory, competitive gauge for lenders.

Points need constant examination and updating. Discount points are generally charged on below-market rate loans and can be viewed as prepaid interest. In exchange for a lower rate, the borrower pays more money up front at the time the loan closes. One point is equal to 1 percent of the loan amount.

For example, let’s say a borrower wants a loan at 3.25 percent when the market is at 4 percent. To get that lower rate, a borrower would probably have to pay around three discount points. If the loan amount were $160,000, one discount point would amount to $1,600 and three points would be $4,800.

Points once differed from loan origination fees and were charged only on below-market government loans: Federal Housing Administration and Veterans Administration mortgages. Now, points are often tossed into the same basket. A loan origination fee comes under the points category. When conventional loans are discounted to a lower rate, lenders like to use the term “buydown” to describe points.

Points on government loans used to change dramatically due to a variety of reasons, including the pressure on the dollar, fluctuating stock market and prime rate. This fluctuation was one of the reasons lenders began offering “locks,” or the chance for the borrower to lock in a specific fee and rate for a specific time period.

Points may be deducted fully on the federal income-tax return for the year they were paid only if proceeds of the mortgage are used to buy or improve a home. When the mortgage-loan proceeds are used to pay off an old mortgage or to finance a family wedding, for example, points must be deducted over the life of the loan.

When, and how, may consumers deduct discount points from their income taxes? Here are two examples the IRS used in explaining the deductibility of points.

1. A taxpayer borrowed $100,000 for 30 years to pay off the existing mortgage on his home. He was charged 3.6 points, or $3,600. He paid the points from separate funds (not subtracted from the mortgage proceeds). Because the proceeds were used solely to pay off the old mortgage, the points must be deducted over the life of the loan.

2. A taxpayer borrowed $100,000 for 30 years and used $80,000 of the money to pay off an existing mortgage. The other $20,000 was spent for improvements on the home. The taxpayer was charged $3,600 in points that were paid from separate funds.

Twenty percent of the points, or $720, may be deducted in the year paid. The remainder must be written off over the remaining term of the loan.

Points do serve a purpose, although the taste is often sour. Persons seeking a low down payment, low-rate loan such as an FHA loan, often can get into a home with a down payment of 3 percent or less. Conventional loans typically require a down payment of 20 percent. By paying points, the low-down buyer can qualify easier for the low-rate loan because the monthly mortgage payments will be less.

For example, a lender will generally require less income for a borrower to qualify for a 3 percent loan than a 4.5 percent loan. But to get the 3 percent loan, more money is required up front (points). It’s a pay-me-now or pay-me-later proposition.

Borrowers often struggle, and many simply do not understand, how points affect their overall costs. Things to consider are how long you will stay in the house and the deductibility potential.

As a rule of thumb, some analysts equate one point with about one-quarter percent on the interest rate. So a 3.75 percent interest rate with 2 points would roughly be equivalent to a 4 percent rate with 1 point for the first few years of the loan.

According to the Mortgage Bankers Association of America, a 4.5 percent loan with 1 point can be cheaper than a 4 percent loan with 3 points over about the first five years. That’s because the points raise the effective rate of the 4 percent loan early in the term.

Now, are you going to stay put for five years? It’s all about timing.