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No-cost mortgages? Factor taxes into the equation

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in Small Business Tax,Small Business Tax Deduction Strategies

You’ve probably seen the ads for “no-cost mortgages” on TV or heard them on the radio. The pitch often appeals to potential homebuyers who want to avoid closing costs.

Strategy: Crunch all the numbers before you commit. Most important, don’t forget to take taxes into account.

Let’s look at an example recently illustrated in The Wall Street Journal.

Facts: A mortgage lender offers you a higher interest rate in exchange for a credit to cover your closing costs. Assuming a loan amount of $300,000 and closing costs of $2,600, you’re given two choices:

  1. A 30-year fixed-rate mortgage at 3.5% with no points and $2,600 in closing costs.
  2. A 30-year fixed-rate mortgage at 4% with no points and no closing costs.

In comparing the two options, here’s how the math breaks down:

The 30-year fixed mortgage at 3.5% contains total interest paid over the life of the loan in the amount of $184,968, so the total cost of the mortgage (computed by adding the closing costs to the interest paid over the full term) is $187,568. With the 30-year fixed rate no-cost option at 4%, the total interest over the full term of the loan comes to $215,609. The total cost difference is $28,041, or about $85 per month.

Therefore, if the closing costs are $2,600, you would actually break even in about 30 months by paying the closing costs and forgoing the no-cost option.

But this computation ignores the tax deduction factor. Assuming the mortgage interest is fully deductible, a taxpayer would recoup the extra interest cost even sooner.

A good rule of thumb is that a no-cost loan makes sense only if you intend to stay in your home for 2½ years or less. It’s a gray area between 2½ and five years. After five years, it rarely makes sense.

Tip: Generally, points paid on a home acquisition mortgage are currently deductible, but points paid to refinance a mortgage generally must be amortized over the life of the loan.

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