In This Chapter

Points get a bum rap in the mortgage business. Most clients complain bitterly if you suggest a loan that has points, and I’ve never understood that. If you know you’re going to be in a house for at least five years, points are the best thing since sliced white bread. For the mortgage broker, each point paid means more money in your pocket. It’s a win-win situation.

So before your clients rule out any loan that has points attached to it, you need to educate them about the advantages—and yes, disadvantages—of points.

In this chapter, you’ll learn how, when, and why to advise your clients to use points.

Buying a house is an expensive proposition. Tell your clients that they need to put even more money up front at the closing and they’re likely to balk. But if they understand that these up-front charges will actually save them money in the long run, it’s likely to make a difference.

Points are charges levied by the lender, payable at closing, to obtain a certain mortgage. Each point costs 1 percent of the loan and is considered, for tax purposes, prepaid interest. Points may also be called loan origination fees, loan discount, or discount points.

Every loan has a par rate which is the lowest interest rate at which a loan will be made without charging discount points. If a loan is procured at less than par, discount points are charged. So if the par rate is 5.625 percent, zero points, to get a loan at 5.25 percent, the borrower would have to pay at least 1 point.

Here’s how it works.

Start with the loan options offered by one lender for a loan of $100,000:

* Points owed were actually 1.125

** Points owed were actually 1.750

Would a client be willing to lower his interest rate by .375 percent (1 point) or up to

.5 percent (2 points) over the course of a 15-year mortgage for less than $2,000?

What would his monthly payments be for a loan at each rate?

Assume the loan is for $100,000, with a down payment of 20 percent or more:

On a simple level, it would take a little more than six years to recoup the cost of the points. After that, the buyer would be saving $26.41 a month or $316.92 a year choosing the lowest interest rate. And that’s not even including the reduced loan balance over the lifetime of the loan for having a lower interest rate.

Now let’s look at a 7/1 ARM and see the effect of paying points. Does it still pay?

Assume the loan is for $100,000, with a down payment of 20 percent. For this loan, there is no prepayment penalty and the interest rate is constant for seven years and then adjusted every year thereafter. The interest rate cannot increase or decrease by more than 5 percent on the first interest rate adjustment date. Starting with the second interest rate adjustment date, the interest rate cannot increase or decrease by more than 2 percent from the interest rate in effect immediately prior to the interest rate adjustment. There is a life of loan interest rate ceiling equal to the sum of the initial interest rate plus 5 percent.

Bottom line: the rate can’t go higher than 11.5 percent if the borrower takes the loan with an interest rate of 6.5 percent, with no points; 10.625 percent if he pays one point; and 10.375 percent if he pays 2 points. In other words, by taking an ARM, the borrower is gambling that the rates will not go up, or at least not much. But in any case, while the rate reduction from paying points applies only to the starting rate, a lower starting rate usually means a lower maximum rate, too.

So for the first seven years, when the interest rate cannot be adjusted, here’s what he would pay.

On a simple level, it would take not quite three years to recoup the cost of two points ($2,000). After that, the buyer would be saving $60.64 a month or $727.68 a year choosing the lower interest rate. And that’s not even including the reduced loan balance over the lifetime of the loan for having a lower interest rate.

But, and here’s where the calculations get more complicated, these calculations haven’t considered equity growth and lost interest earnings. Those calculations are more complex and must include a borrower’s tax bracket in the calculations and the current investment rate, what the borrower can earn on his money. There is software that can run limitless scenarios that can provide your client with figures customized to his circumstances.

On my website, www.facmortgage.com, you can practice with different factors (rates, tax bracket, investment rates) to get a feel for how points can pay off.

Paying points is generally a good thing, but it does require an additional outlay of cash. And there’s no marketability of having a lower interest rate. The buyer has used some of his liquid assets to secure the lower interest rate, but he can’t sell that rate to raise immediate cash should he need it.

Here are the basic rules of thumb:

One way to avoid a cash outlay for the points is to roll the points into the loan. But of course, it increases the loan balance. The amount of time needed to hit a break-even point and then benefit from a lower interest rate is longer. But there are important caveats:

Points get a bad rap. Be sure and discuss the very real advantages of points if the buyer intends to remain in the house.

Paying points often pays off in the long run, but their tax value is immediate. According to the IRS, a borrower can deduct the points in full in the year they are paid, if all the following requirements are met:

Points that do not meet these requirements may be deductible over the life of the loan. Points paid for refinancing generally can only be deducted over the life of the new mortgage.

We’ll talk more about refinancing and home equity loans in Chapter 21, but it’s worth noting that paying points to refinance a mortgage or take out a home equity loan also makes sense. Again, the first question has to be: How long is the borrower planning to be in the house? If the intention is to stay at least five years, then points generally are worth it, certainly on a 15- or 30-year fixed mortgage.

But the tax implications are different. In most refinancing cases, the homeowner deducts the points over the lifetime of the loan. In general, here’s how it works.

Assuming a $100,000 loan, a borrower refinances his mortgage and pays $2,000 for 2 points for a 30-year mortgage. A 30-year mortgage has 360 payments. The borrower could deduct $66.72 each year of the mortgage ($5.56 per payment × 12 = $66.72).

The Exception to the Rule

If the borrower uses part of the refinanced mortgage proceeds to improve the primary home and meets the first six requirements we described above when discussing a first mortgage, then the borrower can fully deduct that part of the points related to the improvement in the year that the borrower paid them with his own funds.

But if the borrower uses the refinancing to pay other expenses, such as college tuition or to buy a new car, then he must amortize the points deduction over the life of the loan.

The Serial Refinancer

When mortgage rates continue to drop, some homeowners may decide to refinance a second (or third or fourth) time. What happens to the remainder of the points being amortized on that first refinance?

It gets complicated.

Let’s go back to the example above. The borrower has decided to refinance after four years. He’s amortized the $2,000 he paid in points from the first refinance, and has deducted a total of $266.88 over the four years. That leaves $1733.22 remaining. He paid another 2 points, $2,000, for a new, 30-year refinance.

If a client refinances a second time, he can take a tax deduction of the leftover points from the first refinancing. For example, let’s say he paid 2 points the first time he refinanced. Two years later, he refinances again. Since the tax deduction of refinancing points is amortized over the length of the loan, he is limited to deducting only ⅓0 of the points each year (presuming a 30-year mortgage). After just two years, he would still have a significant amount of undeducted interest on the original points. At the time of the refinancing, however, he can deduct the entire remaining portion of the original points. If he has paid new points for the second refinancing, he begins to deduct that amortized amount as well.

Remind clients of this tax deduction when working with them on their refinance.

A Few More Variations

Let’s suppose that the borrower refinances his home, with a 15-year $100,000 loan, with three points. Two of those points were for prepaid interest, but one of them was charged for services, charges that would normally be stated separately on a settlement sheet, like the mortgage recording fee or appraisal. In this case, the borrower can deduct $2,000 (two points) over the life of the loan, but the remaining point is not deductible. It was a fee for services.

Or the same borrower refinances, is charged 3 points, but one is for services so it’s not deductible. He uses $25,000 of the loan for home improvements and $75,000 to repay his existing mortgage. In this case, the borrower deducts 25 percent of the deductible points ($25,000 ÷ $100,000 = .25) in the first year, $500. He then prorates the rest of the deductible points ($2,000 - $500 = $1,500) over the life of the loan ($1,500 ÷ 180 months). That equals $8.33 per month or $100 per year.

While it’s important that you understand the basic parameters of tax deductions for points, you are not a tax professional. Advise your clients to speak to a tax expert about their personal circumstances.

Sometimes, to facilitate a deal, a seller will offer to pay the points. But the seller cannot deduct them as interest on his return. They are considered a selling expense and can be used to reduce the amount of gain realized.

If the seller pays the points, the buyer may deduct them provided the buyer subtracts the amount from the basis, or cost, of the residence.

Unlike the points we’ve been discussing, which are paid by the borrower to the lender in order to secure a lower interest rate, negative points are paid by the lender to the borrower in order to secure a higher interest rate and cash rebate.

In exchange for originating these loans, the lender pays the mortgage broker a yield spread premium, a rebate for bringing in a higher-interest, and therefore potentially more lucrative, loan. Mortgage brokers must disclose to the customer the yield spread premium. Like the points paid to secure a lower interest rate, each negative point is equal to 1 percent of the loan. For example, for a $100,000 loan with negative 2.5 points, the broker would earn $2,500.

Why would you, in good conscience, steer a customer to a higher interest rate? Because it’s the best deal for the client.

For the cash-strapped client, negative points can be the difference between buying a home or not. In exchange for a higher interest rate, the lender gives the borrower a cash rebate that can be used for settlement costs. But since these funds are limited to paying settlement costs, the client should never take more negative points than he can use to defray those costs. The remainder of the rebate is lost to the client.

For example, a lender might have the following rate/points programs on a 30-year fixed rate mortgage:

If a customer’s settlement costs on a $100,000 loan are $2,500, then the negative points in the aforementioned programs could be fully used. But if the settlement costs were only $1,800, the client would not pocket the remaining $700.

Another borrower who might be interested in negative points is the client who doesn’t intend to hold on to the loan for long. The rebate, even with a higher interest rate, may be a selling point. He uses the cash to pay settlement costs, flips the property quickly, and is in and out fast.

But for those who intend to keep the mortgage for an extended period, a higher interest rate is less appealing, even with a rebate.

The Least You Need to Know