A reader asked “How are points determined in a mortgage?” There are actually two questions here and a bit of explanation of the basics of “points” will help answer both. Points, or more specifically discount points, are prepaid interest on a mortgage loan. They are sometimes called a “buydown” of the interest rate. The principal in paying points is that by prepaying some of the interest, the annual interest rate and the monthly payment can be reduced. A point is simply 1% of the loan amount. According to MortgageQuotes.com, “A general rule of thumb is that one full Discount Point will lower your fixed interest rate .250% or your adjustable rate .375%.”
Done right, paying points can allow a buyer to purchase a higher priced home. Since paying points can allow for a higher purchase price, some sellers will pay points for the buyer.
So, the reader’s question could be “How do we determine who pays the points?” or “How do we determine how many points to pay?”
The answer to the first question is that it’s a matter of negotiation. Traditionally there have been limits on buyers paying points on Veteran’s Administration loans and, because VA loans almost created the suburban real estate marketplace after World War II, a lot of the VA requirements were assumed by many people to be legal requirements for all loans. This wasn’t, and isn’t, the case. Who pays points is entirely a matter of negotiation. Though some loan requirements may still not allow the buyer to pay, this simply means that if the seller is unwilling to pay points, the options are to nix the deal or to not pay points at all.
Which gives a big hint as to the answer to “How do we determine how many points to pay?” The answer is, whatever makes your budget work. Don’t confuse points with the origination fee charged by the lender, which is also usually expressed as a percentage of the loan amount. (Unfortunately, the Mortgage Bankers Association’s weekly reports on interest rates now combine discount points and origination fees under the blanket term “points”, confusing the issue.) You can pay points or not pay points and the amount you pay is entirely determined by the trade-off you, as a buyer, want to make between cash up front and monthly payment. Of course, if the seller is willing to pay points, but won’t negotiate on price, as a buyer you’d want to maximize the amount the seller will pay. As a seller, your chief concern is how paying points versus negotiating on price affect your post-tax bottom line. Tour real estate professional, along with your tax professional, should help you put pencil to paper to determine that when evaluating offers.
Since discount points are interest and interest can be tax deductible in some situations, both buyers and sellers will want to consider the tax implications of paying points and of negotiating points instead of an equivalent reduction in price. Specific factors to discuss with your professional tax planner are, as a seller, selling expenses versus reduced sale price and, as a buyer, amortizing points over the loan.
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