TO PAY or NOT to PAY?

Is it Worth Paying Points or Closing Cost?

The Refinancing of Home Loans caught on like wildfire in the 1990s with the advent of the No-Cost Loan. Once people realized they could save thousands of dollars and Refinance their Home to get a better interest rate, and do this with no Out-of-Pocket Costs, a generation of refi-junkies came into being.

The No-Cost Loan usually carries an interest rate of 3/8 to 1/2 percent higher than a loan that includes the payment of Points. But because there is no cost of Points to recapture over time, there is no “break even” mark to take into consideration.

This works particularly well for people who are purchasing a Home, but not planning on being in the Home for a long period of time. If a couple decides to buy a fixer-upper that they will use as their primary residence and sell in less than three years, it would make good sense for them to get a no-cost purchase loan. This frees up money for their down payment and repairs. It’s just a matter of knowing how long the money is needed, and whether the cost of paying points would be recouped while the borrowers are still in the loan.

One should also take Tax benefits into consideration while considering their options for financing. Closing costs are only Tax deductible if the primary residence is sold and the gain exceeds IRS allowances for Tax-free Capital Gain. (See IRS Pub. 523, Selling Your Home.*) However, points are deductible in the year they are paid. Smart homebuyers can get a tax break by buying down the equivalent rate of their Closing Costs by paying about 1.5 points (1.5% of the loan amount). Essentially, the Borrower can trade Non-deductible Closing Costs for Tax-deductible Points. The amount of Points paid will vary depending on the size of the Home Loan and the amount of the Closing fees.

Let’s look at an example:

If the Borrower is purchasing a Home with a $500,000 Home Loan at no Points, and the Non-Tax-deductible Closing Costs are in the range of $5,000, then the Closing Costs are the equivalent of 1 Point. ($5,000 Closing Costs/$500,000 Home Loan = 1% or 1 point.) If a Borrower in the 35% Federal Tax Bracket paid the 1 Point in lieu of the $5,000 in Closing Costs, the result would be a cash tax benefit of $1,750. Therefore, by “trading” Tax Deductible Points for Non-Deductible Closing Costs, the Buyer can benefit substantially in the existing Tax year.

I do much more than quote rates for my Clients. I find it is best to know what my Client’s long-term goals are as they enter into the loan process. By knowing their intimate needs, I can assist them in making intelligent choices on finance options that are congruent with their “Big Picture.”

* The IRS allows a tax-free capital gain of $500,000 for married couples or $250,000 for single individuals. See http://www.irs.gov/pub/irs-pdf/p523.pdf