Refinancing is the process of paying off your current mortgage and taking out a new one. If you're thinking about refinancing but it's been some time since your last mortgage transaction, you may want to refresh your understanding of points.
Lower Your Rate with Points
Points are charges paid to the lender and are usually paid at closing. A point equals one percent of the loan amount. So, if you have a $250,000 loan, one point equals $2,500.
Before you refinance, compare different lenders' rates and points. Usually, a lower rate carries more points. For example, one lender may charge 6.5% interest with no points and another lender may offer 6.375% interest with one point. As a general rule, each point that you pay will reduce the interest rate offered by the lender by about one-eighth of one percent, or 0.125%.
You may want to consider getting a lower interest rate by paying additional points. Reducing the interest rate by paying points is called "buying down" the rate. In some instances, a lender may finance the points so you will not have to pay them up front. If not, the cost of the points will be added to the other closing fees for the loan.
When to Use Points
If you plan to move within a few years of refinancing, paying points to buy down your interest rate might not be a good idea. The general rule is that it takes about 5 to 7 years to recover the cost of points paid at closing.
Consider James Morgan, who has a 30-year fixed-rate mortgage loan for $200,000. His loan interest rate is 6.75% with one point and his monthly payment of principal and interest is $1,297.20. If he did not pay the point, his interest rate would be 6.875% and his monthly payment would be $1,313.86. Paying the point saves him $16.66 per month, or roughly $200 per year.
In 10 years, James will recoup the point he paid to get the lower rate. Because he will continue to pay lower payments each month after that, James will benefit from the lower rate. Over the life of his 30-year loan, James will save roughly $6,000 in monthly payments due to the lower rate in exchange for the upfront cost of $2,000 for the point. But if he moves after just a few years, he will not recover his costs.
Tax Tips
Note: The following includes an overview of tax laws and is not intended as legal advice. You should consult a tax advisor to get answers to your specific tax questions.
If you itemize deductions on your tax return, you should be able to deduct the points you pay on the refinanced loan. However, points paid in a refinance transaction usually must be deducted over the life of the loan, rather than as a lump sum in the year they were paid. For example, rather than deducting the entire $2,000 in points that he paid when he refinanced, James Morgan will deduct $5.56 per month for the next 30 years. ($2,000 / 360 monthly payments = $5.56 per month deduction).
There are two exceptions to the requirement that you deduct refinance points over the life of the loan. First, if you refinance more than once, you can deduct all remaining undeducted points on your first refinanced loan at the time you do your second refinance (and so on for each additional refinance transaction). Second, any points you paid in a refinance transaction for the purpose of financing home improvements may be fully deductible in the year they were paid.
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