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One of the best justifications for owning a home, at least
for financial reasons, is the tax savings that result
from deducting mortgage interest. The deduction for
mortgage interest stands as one of the few remaining
tax deductions for the typical middle class taxpayer.
Despite the changes to the tax code over the past several
years and the repeal and limitation of many non-housing
itemized deductions, mortgage interest is still deductible.
On first and second mortgages and home equity lines
of credit (with some limitations) for first and second
homes, your mortgage interest deduction is still a good
financial incentive to buy a home.
Under
the current tax code, mortgage interest on first and
second homes is generally deductible as long as these
loans total less than $1.1 million, making homeownership
one of the best ways to trim your tax bill. The examples
below illustrate how the mortgage income tax deduction
affects the after-tax homeownership.
Listed
below are the topics covered in this document.
- Homeowner
Profile
Gross Income - $35,500
House Price/Mortgage Size - $115,000 - $23,000 down
= $92,000
Loan Type - 30-year Fixed-Rate mortgage at 10%
Property Tax - 1.23% of home value ($1,415)
Filing Status - Files jointly/four exemptions
According
to the tax code, this homeowner's deductions for mortgage
interest and property taxes would be evaluated at a
15 percent marginal tax rate. Non-housing itemized deductions
(i.e., state and local taxes, non-mortgage interest
and so on) is estimated at $2,000 and the standard deduction
is $5,450. Under the current tax system, the homeowner
saves $1,071 because of the mortgage interest deduction.
You can figure what your own costs and savings will
be by substituting your own tax figures for those on
the chart.
- Example
of the impact of the Mortgage Income Tax Deduction
on Annual Homeownership Costs:
- Before-Tax
Homeownership Costs
Mortgage Interest=$9,177
Property Taxes=1,415
Total of Before-Tax Homeownership Costs=10,592
- Itemized
Deductions
- Homeownership
Deductions
Mortgage Interest= $9,177
Property Taxes=1,415
Non-homeownership Deductions= 2,000
Total= 12,592
- Standard
Deductions=5,450
- Total
Itemized Deductions=$7,142
Multiply Total Itemized Deductions by Marginal
Tax Rate to get Homeownership Tax Savings:
$7,142
x .15 = $1,071
- After
Tax Homeownership Costs = Homeownership Tax -
Before Tax Savings:
$10,592 - 1,071 = $9,521
Under
the current tax system, there are two different kinds
if debt. Money you borrow to buy, build or substantially
improve your residence is called "acquisition indebtedness."
Money you borrow against the equity in your home, or
money you take out when you refinance your home for
any reason except home improvement, is called "equity
indebtedness."
When
you borrowed the money is also important. Home loans
taken out before October 14, 1987, are exempted from
the new rules. You may fully deduct interest paid on
these loans, regardless of their size or what you used
them for. Any refinanced debt you incurred before October
14, 1987, is rolled into your total acquisition indebtedness.
On loans made on or after October 14, 1987, you can
deduct mortgage interest paid on acquisition indebtedness
up to a total of 1.0 million. This means you could buy
a home for $250,000, a beach home for $200,000, and
add a family room to your first house for another $100,000,
and still have $450,000 to spend on these homes for
further improvements before you reached your limit for
interest deductibility. The $1. 0 million is not cumulative.
As you pay off a loan, you would add that amount to
your total purchasing or improving up to two residences.
Your
equity indebtedness limit is $100,000. That means that
you can borrow up to $100,000 of the equity in your
home and use it for whatever you want. This is a change
from the pre-1986 tax rule that limited your equity
borrowing beyond the purchase price to certain qualified
expenses, such as home improvements, medical and education
expenses.
Interest
rate have declined recently, and many homeowners have
taken advantage of this drop by refinancing their mortgages.
In the past, refinancing your mortgage has proved to
be an excellent opportunity both to lower your interest
rate and monthly payment and take equity out of your
home.
When
refinancing your mortgage, you will probably pay 3 percent
to 6 percent of the loan amount in closing costs-for
surveys, legal fees and paperwork fees. Many of these
closing costs are deductible, but not necessarily in
the year that you refinance. I f you are considering
refinancing your mortgage under the current tax rules,
however, there are a couple of things to bear in mind.
If you refinanced before October 14,1987, for a longer
term than was remaining on the pre-October 14 loan,
you may only de duct the interest paid on the mortgage
for the term that was remaining on the old loan. So
if you refinanced a loan with 15 years remaining for
a 30-year loan with lower payments, you can only deduct
the mortgage interest paid on the new loan for 15 year
s. The one exception is if you had a balloon mortgage
payment come due after October 13,1987 and you refinanced
it to a loan of not more than 30 years; you get the
deductibility for the full term of the longer loan.
Any refinanced debt you incurred before October 14,1987,
is rolled into your total acquisition indebtedness.
In
the past many homeowners have refinanced mortgages on
their appreciating properties to draw on their equity
to buy a new car or take a vacation. Under the new tax
system, homeowners will no longer have unlimited mortgage
interest deductions when drawing on equity. Any equity
debt incurred is subject to a limit of the amount of
on equity. Any equity debt incurred is subject to a
limit of the amount of the existing debt plus $100,000.
Say, for instance, that you bought your house 10 years
ago and have seen the property grow in value from $70,000
to $230,000. If you refinance your mortgage (on which
you now owe $50,000), you may only deduct the interest
paid on the total of your acquisition indebtedness in
the property ($50,000) plus $100,000. You will be able
to deduct the interest paid on $150,000.
A
second mortgage allows the homeowner to cash in on some
of the equity that has built up in the home over time.
Some lenders call a second mortgage a "junior lien."
Getting a second mortgage is very much like taking out
your first mortgage (i.e. you w ill be required to pay
closing costs of 3 percent to 6 percent of the loan
value).
You
may deduct the interest paid on second mortgages made
on or after October 13,1987, up to the $100,000 limit
had already been reached when the first mortgage was
taken out. The amount of second mortgages made before
that date is part of your acquisition indebtedness total
figure. This means that if you had $50,000 left on your
first mortgage as of that date, and had taken out a
$25,000 second mortgage on the property prior to October
14,1987, you would have an acquisition indebtedness
of $75,000.
While
the 1986 tax reform called for consumer interest deducibility
to be phased out by 1991, interest deductions on equity
indebtedness now are limited only by the $100,000 cap.
This means that interest paid on home equity lines of
credit - loans secure d by your principal or second
home - is still deductible.
Where
the traditional second mortgage gives the homeowner
money in one lump sum the home equity line of credit
allows homeowners to use the equity in their home like
a giant credit card. The lender allows the homeowner
to borrow at will against the equity in the home, and
charges interest only on the portion of the equity borrowed
against. Therefore, your interest deductions for a home
equity line of credit depend on whether you borrow against
the equity during that year.
As
we've said, the mortgage interest tax deduction is one
of the best financial reasons to buy a home. You may
be wondering, however, what total interest charges are
like on the typical home loan. In the chart, you can
compare a 30-year fixed-rate loan with 15-year and bi-weekly
mortgages for the same amount. As you can see, the amount
of interest you pay over the life of your loan depends
on what kind of mortgage you determine is best for you.
|
30
Year Fixed RateAt 10% |
15
Year Fixed Rate At 10% |
Bi-Weekly
Mortgage At 10% |
| Monthly
Payment |
$658 |
$806 |
$658
($329 X 2) |
| Interest
Cost First Year |
$7,481 |
$7,398
|
$7,434 |
| Fourth
Year |
$7,336 |
$6,606
|
$7,061 |
| Mortgage
Balance First Year |
$74,583 |
$72,726 |
$74,476 |
| Fourth
Year |
$73,052
|
$64,732 |
$69,817
|
| Interest
Cost/Life |
$161,942 |
$70,062 |
$104,331 |
| Difference
from 30-year |
|
-$91,880 |
-$57,611
|
The IRS allows a Capital Gains Exclusion of either $250K or $500K (single or married) on the sale of primary residences. There is no life-time cap on this exclusion. Every 2 years of residence during a 5 year period, you can sell your home and pocket the gain, up to the exclusion, and start over. In other words, assuming that your only residence is your home, every 2 years you can sell your home, pocket the gain and do it again!
- Is
the next interest rate adjustment on your existing
loan likely to increase your monthly payments substantially?
Will the new interest rate be two or three percentage
points higher than the prevailing rates being offered
for either fixed-rate loans or other ARMs?
- If
the current mortgage sets a cap on your monthly payments,
are those payments large enough to pay off your loan
by the end of the original term? Will refinancing
a new ARM or a fixed-rate enable you to pay your loan
in full by the end of the term?
The
fees described below are the charges that you most likely
to encounter in a refinancing.
- Application
Fees
This charge imposed by your lender covers the initial
costs of processing you loan request and checking
your credit report.
- Title
Search and Title Insurance
This charge will cover the cost of examining the public
record to confirm ownership of the real estate. It
also covers the cost of a policy, usually issued by
a title insurance company, that insures the policy
holder in a specific amount for any loss caused by
discrepancies in the title to the property. Be sure
to ask the company carrying the present policy if
it can re-issue your policy at a re-issue rate. You
could save up to 70 percent of what it would cost
you for a new policy.
- Lender's
Attorney's Review Fees
The lender will usually charge you for fees paid to
the lawyer or company that conducts the closing for
the lender. Settlements are conducted by lending institutions,
title insurance companies, escrow companies, real
estate brokers, and attorneys for the buyer and seller.
In most situations, the person conducting the settlement
is providing a service to the lender. You may want
to retain your own attorney to represent you at all
stages of the transaction, including settlement.
- Loan
Origination Fees and Discount Points
The origination fee is charged for the lender's work
in evaluating and preparing your mortgage loan. Discount
points are prepaid finance charges imposed by the
lender at closing to increase the lender's yield beyond
the stated interest rate on the mortgage note. One
point equals one percent of the loan amount. For example,
one point on a $75,000 loan would be $750. In some
cases, the points you pay can be financed by adding
them to the loan amount. The total number of points
a lender charges will depend on market conditions
and the interest rate to be charged.
- Appraisal
Fee
This fee pays for an appraisal which is a supportable
and defensible estimate or opinion of the value of
the property.
- Prepayment
Penalty
A prepayment penalty on your present mortgage could
be the greatest determent to refinancing. The practice
of charging money for an early pay-off of the existing
mortgage loan varies be state, type of lender, and
type of loan. Prepayment penalties are forbidden on
various loan including loan from federally chartered
credit unions, FHA and VA loans, and some other home-purchase
loans. The mortgage documents for your existing loan
will state if there is a penalty for prepayment. In
some loans, you may be charged interest for the full
month in which your prepay your loan.
- Miscellaneous
Depending on the type of loan you have and other factors,
another major expense you might face is the fee for
a VA loan guarantee, FHA mortgage insurance, or private
mortgage insurance. There are a few other closing
costs in addition to these.
In
conclusion, a homeowner should plan on paying an average
of 3 to 6 percent of the outstanding principal in refinancing
costs, plus any prepayment penalties and the costs of
paying off any second mortgages that may exist. One
way of saving on some of these costs is to check first
with the lender who holds your current mortgage. The
lender may be willing to waive some of them, especially
if the work relating to the mortgage closing is still
current. This could include the fees for the title search,
surveys, inspections, and so on.
The
information contained in this brochure is intended to
help you ask the right questions when considering refinancing
your loan. It is not a replacement for professional
advice. Talk with mortgage lenders, real estate agents,
attorneys, and other advisors about lending practices,
mortgage instruments, and your own interests before
you commit to any specific loan.
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