Thanks to IRC §1031, a properly structured exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. IRC §1031 (a)(1) states:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
To understand the powerful protection an exchange offers, consider the following example:
- An investor has a $200,000 capital gain and incurs a tax liability of approximately $50,000 in combined taxes (depreciation recapture, federal and state capital gain taxes) when the property is sold. Only $130,000 remains to reinvest in another property.
- Assuming a 25% down payment and a 75% loan-to-value ratio, the seller would only be able to purchase a $520,000 new property.
- If the same investor chose to exchange, however, he or she would be able to reinvest the entire $200,000 of equity in the purchase of $800,000 in real estate, assuming the same down payment and loan-to-value ratios.
As the above example demonstrates, exchanges protect investors from capital gain taxes as well as facilitating significant portfolio growth and increased return on investment. In order to access the full potential of these benefits, it is crucial to have a comprehensive knowledge of the exchange process and the IRC. For instance, an accurate understanding of the key term “like-kind” – often mistakenly thought to mean the same exact types of property – can reveal possibilities that might have been dismissed or overlooked. I will act as your resource to obtain accurate and thorough information about the entire exchange process.
Points, also known as Discount Points, are a source of confusion for many home loan borrowers. When shopping for a loan, your clients have many options with respect to paying points.
A point is calculated as a percentage of the loan amount. For example, 1 point charged for a $100,000 loan would be $1000, and ½ point for the same loan would be $500.
Although “points” are part of the closing costs, they are not considered loan fees. They are an optional feature of the loan, which enable the borrower to buy the interest rate up or down. Interest rates are generally presented in increments of eighths.
The table below shows how different interest rates and points are typically shown. This example is also for a $100,000 loan amount. To get a loan with a rate of 6.00%, the borrower would not pay any points; however, to get a rate of 5.75%, 1.00 point ($1000) would be required. Example of Rates & Points
Break Even Analysis
When considering whether or not to pay points, most borrowers use the Break Even Analysis method. By paying points and obtaining a lower rate, your client will have a lower payment. It’s up to your client to decide whether the monthly savings is worth the up front cost of the points. In the same example above, a $100,000 loan at 6.00% for 30 years has a monthly payment of $600. If your client pays 1.00 point ($1000), his/her rate would be 5.75% and the monthly payment would be $584. This represents a monthly savings of $16. So, in effect, your client would have paid $1000 up front to save $16 per month. At this rate, it would take just over 62 months (over 5 years) to recoup his/her investment or “break even”.
What to Consider
Using the Break Even Analysis, take the following into consideration when helping your clients decide how many points to pay:
Your clients should pay zero or close to zero points if:
- Clients plan to stay in their home for less than 3 – 4 years
- Clients think they will refinance their loan within the next few years
- Clients are applying for an adjustable rate mortgage
Your clients should consider paying 1 or more points if:
- Clients plan to stay in their home for more that 5 years
- Clients plan to keep their property as an investment after they move
- Clients don’t plan on refinancing in the near future
Other Things to Consider
Tax deductibility is another factor to consider. For a loan to purchase a home, the points paid can typically be considered tax deductible in the year they are paid; however, with a refinance loan, the points paid can only be deducted over the term of the loan. Always refer recommend that your clients consult their tax adviser for specific tax rules.
Another important consideration is how to pay for the points. Although paying points will reduce your clients’ monthly payment, it may not always be their best option to pay them. Homebuyers are often strapped for cash and the money that would be allotted for points may be better used for furniture, new carpet or window coverings, especially if the alternative was to use a credit card. On a refinance transaction, the points can usually be included in the loan amount, rather than being paid out of pocket.
Since 1983, the city of Boston has elected to apply a residential exemption to residential property that serves as a principal residence of its owner. The value of the residential exemption in FY 2002 was $80,031. This value is subtracted from the total full valuation for residential taxpayers who qualify, this represented a tax dollar savings of $881.14.
Residential Exemption Increases
In fiscal year taxpayers who own and occupy their home can saved over $800 off their tax bill by having a portion of their property value exempted from taxation. To qualify for the residential exemption, homeowners must show proof that the property is their principal place of residence. This year, the residential exemption was over $361 more than last year’s amount due to the Legislature’s approval of Mayor Menino’s petition to increase the exemption.
The value of the exemption is subtracted from the total full valuation. For Fiscal Year 2003, the Residential Exemption has increased to 30% of the average value of all residential property in the City. For FY 2003, the residential exemption value is $87,524. Residential taxpayers who qualify, will save $988.15 off their tax bill.
Here are some tips that could save you a lot of time, money and trouble.
- Plan ahead. Establish good credit and save as much as you can for the down payment and closing costs.
- Get pre-approved online before you start looking. Not only do real estate agents prefer working with pre-qualified buyers; you will have more negotiating power and an edge over homebuyers who are not pre-approved.
- Set a budget and stick to it. Our Online Calculator can help you determine a comfortable price range.
- Know what you really want in a home. How long will you live there? Is your family growing? What are the schools like? How long is your commute? Consider every angle before diving in.
- Make a reasonable offer. To determine a fair value on the home, ask your real estate agent for a comparative market analysis listing all the sales prices of other houses in the neighborhood.
- Choose your loan (and your lender) carefully. For some tips, see the question in this section about comparing loans.
- Consult with your lender before paying off debts. You may qualify even with your existing debt, especially if it frees up more cash for a down payment.
- Keep your day job. If there is a career move in your future, make the move after your loan is approved. Lenders tend to favor a stable employment history.
- Do not shift money around. A lender needs to verify all sources of funds. By leaving everything where it is, the process is a lot easier on everyone involved.
- Do not add to your debt. If you increase your debt by financing a new car, boat, furniture or other large purchase, it could prevent you from qualifying.
- Timing is everything. If you already own a home, you may need to sell your current home to qualify for a new one. If you are renting, simply time the move to the end of the lease.
How much house you can afford depends on how much cash you can put down and how much a creditor will lend you. There are two rules of thumb:
- You can afford a home that’s up to 2 1/2 times your annual gross income.
- Your monthly payments (principal and interest) should be 1/4 of your gross pay, or 1/3 of your take-home pay.
The downpayment and closing costs – how much cash will you need?
Generally speaking, the more money you put down, the lower your mortgage. You can put as little as 3% down, depending on the loan, but you’ll have a higher interest rate. Furthermore, anything less than 20% down will require you to pay Private Mortgage Insurance (PMI) which protects the lender if you can’t make the payments. Also, expect to pay 3% to 6% of the loan amount in closing costs. These are fees required to close the loan including points, insurance, inspections and title fees. To save on closing costs you may ask the seller to pay some of them, in which case the lender simply adds that amount to the price of the house and you finance them with the mortgage. A lender may also ask you to have two months’ mortgage payments in savings when applying for a loan.
The mortgage – how much can you borrow?
A lender will look at your income and your existing debt when evaluating your loan application. They use two ratios as guidelines:
- Housing expense ratio. Your monthly PITI payment (Principal, Interest, Taxes and Insurance) should not exceed 28% of your monthly gross income.
- Debt-to-income ratio. Your long-term debt (any debt that will take over 10 months to pay off – mortgages, car loans, student loans, alimony, child support, credit cards) shouldn’t exceed 36% of your monthly gross income. Lenders aren’t inflexible, however. These are just guidelines. If you can make a large downpayment or if you’ve been paying rent that’s close to the same amount as your proposed mortgage, the lender may bend a little. Use our calculator to see how you fit into these guidelines and to find out how much home you can afford.
If you have a low, 30-year fixed interest rate you’re in good shape. But if any of these Five Reasons applies to your situation, you may want to look into refinancing.
- Decrease monthly payments. If you can get a fixed rate that’s lower than the one you currently have, you can lower your monthly payments.
- Get cash out of your equity. If you have enough equity you can get cash out by refinancing. Just decide how much you want to take out and increase the new loan by that amount. It’s one way to release money for major expenditures like home improvements and college tuition.
- Switch from an adjustable to a fixed rate. If interest rates are increasing and you want the security of a fixed rate, or, if interest rates have fallen below your current rate you can refinance your adjustable loan to get the fixed rate you’re looking for.
- Consolidate debt. You can refinance your mortgage to pay off debt, too. Simply increase the new loan amount by the amount you need and the lender will give you that cash to pay off creditors. You’ll still owe the lender but at a much lower interest rate – and that interest is tax-deductible.
- Pay off your mortgage sooner. If you switch to a shorter term or a bi-weekly payment plan, you can pay off your home earlier and save in interest. And if your current interest rate is higher than the new rate, the difference in monthly payments may not be as big as you’d expect.
Refinancing costs money. Like buying a new home, there are points and fees to consider. Usually it takes at least three years to recoup the costs of refinancing your loan, so if you don’t plan to stay that long it isn’t worth the money. But if your interest rate is high it may be smart to refinance to a lower interest rate, even if it is for the short term. If your mortgage has a prepayment penalty, this is another cost you will incur if you refinance.
Use the reasons in the question above as a guideline and determine whether or not refinancing is the right thing to do. You can also use our refinance analysis calculator to help you decide.
Here’s what you can expect to pay when you refinance:
- The 3-6 Percent Rule
Plan to pay between 3% and 6% of the amount of the new loan amount (if want cash-out, the loan amount will be larger). Yet some lenders offer no-cost refinancing in exchange for a higher rate.
- Getting to the Points
Points play a big part in how much it’ll cost to refinance – the more points you pay, the lower your interest rate. Points are a good idea if you’re planning to stay in your home for a while, but if you’ll be moving soon you should try to avoid paying points altogether.
- Negotiate the Fees
Be aggressive and investigate the fees your lender is asking you to pay. You may not need an appraisal, or your loan-to-value may be such that you no longer need Private Mortgage Insurance. Sometimes if you refinance with your current lender they won’t need a credit report. With a little research it’s amazing how much you can save.
Here, we’ve explained the different loan refinancing fees.
- Application Fee: This covers the initial costs of processing your loan application and checking your credit.
- Appraisal Fee: An appraisal provides an estimate or opinion of your property’s value.
- Title Search and Title Insurance: A Title Search examines the public record to discover if any other party claims ownership of the property. Title Insurance covers you if any discrepancies arise in ownership. (A reissue of the title can save 70% over the cost of a new policy.)
- Lender’s Attorney’s Review Fees: In any financial transaction of this scope, a lawyer’s participation ensures that the lender isn’t legally vulnerable. This fee is passed on to you.
- Loan Origination Fees: This is the cost of evaluating and preparing a mortgage loan.
- These are basically finance charges you pay the lender. One point equals 1% of the loan amount (for example, one point on a $75,000 loan is $750). The total number of points a lender charges depends on market conditions and the loan’s interest rate.
- Prepayment Penalty: Some mortgages require the borrower to pay a penalty if the mortgage is paid off before a certain time. FHA and VA loans, issued by the government, are forbidden to charge prepayment penalties.
- Miscellaneous: Other fees may include costs for a VA loan guarantee, FHA mortgage insurance, private mortgage insurance, credit checks, inspections and other fees and taxes.
How to Save Money Refinancing:
- Research all costs and fees.
- Don’t be afraid to negotiate with your lender.
- Shop around for the lowest rates.
- Check with your current lender for lower rates with costs that are reduced or waived.
- Fixed-Rate Mortgage – interest rates and monthly payments remain unchanged for the life of the loan
- Adjustable-Rate Mortgage – interest rates and monthly payments can go up or down, depending on the market
- Hybrid Loans – a combination of fixed and adjustable mortgages
- How much cash do you have for a downpayment?
- What can you afford in monthly payments?
- How might your financial situation change in the near future and beyond?
- How long do you intend to keep this house?
- How comfortable would you be with the possibility of your monthly payments increasing?
- Discuss these with your lender so they can help you decide which loan would best suit you.
This is the most common loan arrangement in the U.S. With a fixed-rate mortgage the loan’s principal and interest are amortized, or spread out evenly, over the life of the loan, giving you a predictable monthly payment.
The upside is, if rates are low, you can lock in for as long as 30 years and protect yourself against rising rates. However, if rates fall you can’t change your rate without refinancing the loan, and that could cost money.
The 30-year Fixed-Rate Mortgage, the most popular and easiest to qualify for, will give you the lowest payment. But you can also get a 20-, 15- and even a 10-year fixed-rate mortgage if you wish to save interest and pay your home off sooner.
With Adjustable-Rate Mortgages (ARMs) interest rates are tied directly to the economy so your monthly payment could rise or fall. Because you’re essentially sharing the market risks with the lender, you are compensated with an introductory rate that is lower than the going fixed rate. How often does the interest rate change?
That depends on the loan. Changes can occur every six months, annually, once every three years or whenever the mortgage dictates.
How much can my rate change?
Your ARM will stipulate a percentage cap for each adjustment period, which means your interest may not increase beyond that percentage point. If the market holds steady, there may be no increase at all. You may even see your payment decrease if interest rates fall.
How are the rate changes determined?
Every ARM loan is tied to a financial market index, such as CDs, T-Bills or LIBOR rates. Your rate is determined by adding an additional percentage (known as a margin) to that index’s rate. When the index rises or falls, your rate rises or falls with it.
Is there a limit to how much interest I’ll be charged?
Yes. It’s called a ceiling, or lifetime cap. This is a guarantee that your interest rate will never exceed a designated percentage. For instance, if your introductory rate was 5% and you have a lifetime rate cap of 6% (meaning that your interest rate can never increase more than 6% during the life of the loan) then your ceiling would be 11%.
- With a lower initial interest rate (usually 2% to 3% lower than fixed-rate mortgages), qualifying is easier and the payments are more manageable at first.
- You may qualify for a larger loan than you would with a fixed-rate mortgage.
- If you’re only planning to stay a short time the interest rate is likely to stay lower than that of a fixed-rate mortgage.
- If you expect regular pay increases that would cover the increase in your interest, or if you believe interest rates will fall, an ARM might be the wiser choice.
A few words of caution:
Negative Amortization – This happens when a lender allows you to make a payment that doesn’t cover the cost of principal and interest. Watch for this. It may be used as a lure to get you into a home with the promise of low initial payments. Or, a lender may give you a payment cap instead of a rate cap. In this mortgage arrangement, if interest rates increase, your monthly payments could stay the same – but the higher interest will still be charged to your loan, adding to it instead of reducing it. Either way, if you find yourself with a negative amortization ARM, you’ll be adding to your debt.
Discounted interest rates – Sometimes a lender will advertise an unusually low initial rate. This is a discounted rate, and it’s essentially a marketing tool. If your ARM offers a discounted interest rate you are certain to see an increase at your next adjustment period, even if interest rates don’t change.
Administered by the Department of Veterans Affairs, these special loans make housing affordable for U.S. veterans. To qualify you must be a veteran, reservist, on active duty, or a surviving spouse of a veteran with 100% entitlement.
A VA loan is simply a fixed-rate mortgage with a very competitive interest rate. Qualified buyers can also use a VA loan to purchase a home with no money down, no cash reserves, no application fee and reduced closing costs. Some states allow a VA loan for refinancing as well. Many lenders are approved to handle VA loans. Your VA regional office can tell you if you’re qualified.
FHA loans are designed to make housing more affordable for first-time home buyers and those with low to moderate income.
Both fixed- and adjustable-rate FHA loans are available, and in most states, an FHA loan can be used for refinancing. The difference is, they’re insured by the U.S. Department of Housing and Urban Development (HUD). With FHA Insurance, eligible buyers can put down as little as 3% of the FHA appraisal value or the purchase price, whichever is lower. Qualifying standards are not as strict and the rates are slightly better than with conventional loans.
Some adjustable-rate mortgages allow you to convert to a fixed rate at certain specified times. This mitigates some of the risk of fluctuating interest rates, but there will be a substantial fee to do it. And your new fixed rate may be higher than the going fixed rate.
This is an ARM that only adjusts once at five or seven years, then remains fixed for the duration of the loan. Not only will you benefit from a lower rate for the first few years, but the new fixed rate cannot increase by more than 6%. It may even be lower, depending on market conditions. Then again, you also run the risk of adjusting to a much higher rate.
Another ARM choice, the convertible loan offers a fixed rate for the first three, five or seven years, then switches to a traditional ARM that fluctuates with the market. If you strongly believe that interest rates will fall a convertible loan might be a smart move.
These short-term loans begin with low, fixed payments. Then, in five, seven or ten years a single large payment (balloon) for all remaining principal is due. While this saves money up front, coming up with a large payment at the end of the loan may be difficult. Some lenders will allow you to refinance that payment, but some won’t, so be sure you know what you’re getting into.
With a GPM you pay smaller payments that gradually increase and level off after about five years. Lower payments can make it possible for you to afford a bigger home, but they’ll be interest-only payments, adding nothing to the principal. This could put you in a negative amortization situation.
You don’t have to finance your home for 30 years. Granted, the payments will be lower, but you’ll be paying them longer. You could, instead, opt for a period of 20, 15 or even 10 years, pay your home off sooner and save in interest.
Furthermore, lenders offer much more attractive interest rates with short-term loans, so your payments may not be as much as you’d think.
The table below shows you the interest savings on a $100,000 loan at 8.5% interest:
Term Monthly Payment Total Interest Accrued
30 yr $768.91 $176,808.95
20 yr $867.83 $108,277.58
15 yr $984.74 $77,253.12
By paying $215.83 more a month on a 15-year mortgage, you’d save $99,555.83 in interest over a 30-year loan – and own the house in half the time.
There are five factors that determine the ultimate cot of a mortgage.
- The principal, or amount of the loan, is the total amount you borrow (the purchase price minus your down payment).
- The interest rate adds significantly to the cost of your mortgage. Fixed or adjustable, the interest paid at the end of the loan can exceed the original cost of the home itself. For instance, a $100,000 loan balance at 8.5% for 30 years will cost you $277,000 by the time the loan is retired.
- The term of the loan is the length of time until the loan is paid off. A longer term means more interest and higher cost.
- Points are interest paid on the loan and they’re purely optional. You pay points at closing if you want to reduce the interest rate and make your monthly payments smaller. One point equals one percent of the loan amount.
- Fees are paid to the lender at closig to cover the costs of preparing the mortgage. They can vary according to where you live and what type of loan you’re securing. While points and fees are not financed, they still contribute to the cost of the mortgage.
Private Mortgage Insurance, or PMI, is insurance purchased by the buyer to protect the lender in case the buyer defaults on the loan. PMI is generally applied when you put down less than 20% of the home’s purchase price.
The reason is this: With 20% down, you are considered a low risk. Even if you default the lender will probably come out ahead because they’ve only loaned 80% of the home’s value and they can probably recoup at least that amount when they sell the foreclosed property.
But with 5% or 10% down, the lender has a lot more invested in the loan and if you default, they will almost surely lose money. This is why lenders require buyers to purchase PMI if they put down less than 20%. It’s insurance that, no matter what happens, the lender will recoup its investment.