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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 Rate
At 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.
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