Discount Point, also known as point, is 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.
- 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.
- 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.
Discount points paid to refinance an existing mortgage are deducted throughout the loan term.
- Second Mortgage:
For a second mortgage, these discount points are fully deductible in the year they are paid.
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.
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