How Mortgage Points Could Lower Interest Rates

How Homebuyers Can Leverage Mortgage Points to Fight Inflation

2022 has brought many financial challenges to taxpayers. Inflation is at a 40-year high and the Federal Reserve has made aggressive rate hikes to combat it, resulting in a rise in mortgage rates. Additionally, the significant demand and limited supply for houses and increased building costs have resulted in an overall higher cost of homeownership. In this increasing interest rate environment, individuals might consider paying mortgage points to lower their interest rate.

Overview of mortgage points

Mortgage points, also known as discount points, are fees that a borrower pays to the lender to reduce their interest rate. In general, each mortgage point is equal to 1% of the total amount of the mortgage principal. For example, 2.5 points charged on a $100,000 loan equals $2,500. This amount is typically paid directly to the lender at closing in exchange for a lower interest rate, with each point reducing the rate by about .125% to .25%. Of course, the rate reduction can vary by lender and the overall mortgage market environment.

When making the determination as to whether points should be paid, the anticipated time frame for holding the mortgage is an important consideration. This is true for a primary residence, secondary/vacation homes, and rental properties. Applying mortgage points towards the interest rate may be beneficial if the taxpayer is anticipating holding the mortgage for the long term and has sufficient cash flow to cover the additional closing costs as a result. In many cases, the interest expense savings outweigh the upfront cost of the points.

If a taxpayer is planning on selling the home or property in the short term, there is typically not a significant savings by paying points. In all situations, home buyers should determine the break-even point, the opportunity cost, and the future return on investment when weighing the benefits of paying points.

Overview of deductibility of points

As with most tax deductions, there are limitations. Points paid on mortgages are no different. Points are considered prepaid interest and they may be partially, wholly deductible or nondeductible.

1. Fully deductible mortgage points in year paid

• Points paid on a loan to purchase, build, or improve your principal residence (assuming certain requirements are met, among them being that the loan is secured by the property and the points are paid from the taxpayer’s own funds rather than loan proceeds) are fully deductible.

Keep in mind that “fully deductible” only applies to home mortgage indebtedness less than $750,000. If the principal amount of the loan is greater than $750,000, deductibility of points is limited. Note that in 2026, the $750,000 limit is set to increase to $1 million.

2. Amortized mortgage points over life of loan

• Individuals who refinance an existing mortgage on their principal residence must amortize any points paid over the life of the new loan. If the loan is paid off early, property is sold or is refinanced with a new lender, then the remaining balance of points are fully deductible in the year the mortgage is paid off. If any cash proceeds from the loan are used to substantially improve the home an allocation can be made to fully deduct those points, while points paid on the remaining portion of the loan (i.e. original debt) are amortized.
• Individuals who pay points on a loan to purchase, build or improve a principal residence can (but are not required to) amortize points over the life of the loan. This might be beneficial if in the year the points are paid, the standard deduction is taken. In later years, the amortized points are deductible if the taxpayer itemizes.
• Points paid on a loan to purchase, build or improve your principal residence if the points are paid from loan proceeds, rather than directly from taxpayer’s own funds (i.e. down payments, earnest money) must be amortized.
• Points paid to purchase or improve a second home must be amortized.

3. Non–deductible mortgage points

• Points paid to refinance a second home are not deductible.
• Points related to a cash out refi where proceeds are used for anything other than substantially improving the home are not deductible.

Given that the recent increase in mortgage interest rates has slowed the pace of the purchase of new homes, many builders are paying points on behalf of the purchaser to add incentives for purchasers. These points are deductible by the borrower, even though paid by the builder/seller as long as the seller makes a down payment or earnest money deposit or otherwise brings enough cash to closing that is greater than the amount of the points paid.

In addition to the limitations described in this article, there can be additional nuances related to the deductibility of mortgage points as it relates to your particular situation. If you have questions regarding mortgage points or other wealth management opportunities. please contact your Keiter Opportunity Advisor or a member of our Family, Executive, Entrepreneurial Advisory Services for assistance, Email | Call: 804.747.0000.

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