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Pay Discount Point to lower your interest rate

Posted on: 01st Apr, 2004 02:53 am
Discount Point, also known as point, are a kind of fee which a lender charges at the time of closing, when the relevant documents in a mortgage deal are signed. These points include prepaid interest which if paid by a borrower can offer him a loan with lower interest rate for the entire loan term.

For example, Andrew takes a mortgage loan of $100,000 for 10 years at 10% rate of interest. He pays 2 points, that is, 2% of the loan amount (1 point = 1% of the loan amount) which is equal to $2,000. His total payment is $156,924 and total interest throughout the loan term is $56,924. Since he pays points, his interest rate is reduced by 0.125%. The effective rate of interest is 9.875% and he saves $1,656.59 by paying points.

Features:
  • Each discount point is equal to 1% of the loan amount. The greater the number of points paid, the lower is the interest rate. Each point paid on a 30 year fixed rate mortgage reduces the rate by 0.125%. But there are fixed rate and adjustable rate mortgages on which payment of 1 point lowers the rate by 0.250% and 0.375% respectively.

  • Points can also be negative, that is, when a borrower pays -3 points, it means that the lender has paid 3% of the loan amount on behalf of the former. The lender therefore charges a higher interest rate, that is, the rate increases by 3% of its original value.

  • The number of points paid depends on the loan amount offered to a borrower, the closing costs paid by him as well as the loan period. But these points are negotiable, that is there are chances of the lender reducing the actual number of discount points. Through points, lenders earn profit by receiving a lump sum amount at closing and borrowers benefit by getting to repay the loan at comparatively lower interest rate.
Discount points and tax deduction:
Generally, points are deductible with respect to the purpose of the loan.
  1. For First Time Purchase:
    For a mortgage loan taken to purchase a primary residence, discount points are fully tax deductible in the year they are paid. These points are deducted under Schedule A of the IRS 1040 tax return, provided that the deductions are itemized.

    The deduction also applies to cases when the seller pays discount points on behalf of the buyer. However, seller paid points can be deducted only if the home buyer subtracts the amount from the home purchase price.

  2. For Refinance:
    Discount Points can be deducted for the life of the loan. But if you use part of the loan funds for home improvement and satisfy all criteria as required for purchase mortgage points, then such points are deductible in the year you pay them.

  3. For Second Mortgage:
    For a second mortgage, these discount points are fully deductible in the year they are paid.
However, points paid in the form of appraisal fees, notary fees, costs of preparing mortgage note cannot be deducted as they do not contribute to the interest of the loan.

If the mortgage loan is secured by a second home or vacation home and not the borrower's primary residence, then the discounts cannot be fully deducted in the year the loan has been offered. Discount points in this case are amortized over the entire life of the loan. Hence, the tax benefit can be availed throughout the life of the loan.

Thus by paying discount points borrowers not only benefit from low interest rates but also from reduced amount of taxes.
Related ArticlesCalculate it yourself
HOw do I find the amount paid on my settlement papers? In other words the amount I need to use for deduction of my points?
Posted on: 02nd Feb, 2009 03:55 pm
Look for a line item that is labeled "discount points". You should consult an accountant. You could miss out on some legitimate deductions which would more than cover the accountant's fee.
Posted on: 04th Feb, 2009 06:26 pm
How do you find out points generally charged where you live? This is one of the criteria for deducting all the points you paid at one time.
Posted on: 04th Feb, 2010 10:03 pm
I was told by IRS that I could claim points over life of 15 year loan. On the tax form it asks points I am claiming. Do I list original amount or deduct points each year?
Posted on: 06th Mar, 2011 07:28 am
Hi Casandra,

I don't think there is a state wise demarcation as to how many points you'll be able to pay. You and your lender can decide upon the number of discount points you will pay.

To Guest,

You can deduct points each year. You should contact a tax adviser and take his opinion in this regard as well.

Take care.
Posted on: 07th Mar, 2011 01:46 am
"Andrew ... pays 2 points, that is, 2% of the loan amount (1 point = 1% of the loan amount) which is equal to $2,000. Since he pays points, his interest rate is reduced by 0.125%. The effective rate of interest is 9.875% and he saves $1,656.59 by paying points. "
Isn't this incorrect? Andrew paid 2 points, thereby lowering his rate by .250 (.125 x 2). His rate would be 10% - .250 =9.75.
Posted on: 07th Feb, 2012 12:00 pm
As far as this can understood, you're right!! The mortgage interest payment rate should be 9.75%.
Posted on: 07th Feb, 2012 10:56 pm
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