How the Amortization of Points Works

When securing a home loan, borrowers often encounter charges known as “points.” These fees, also called loan origination fees or discount points, are a form of prepaid interest. Lenders offer borrowers the option to pay these points at closing for a lower interest rate over the life of the loan. Each point costs 1% of the total loan amount. Amortization is the practice of spreading an expense, such as the cost of points, across a specific period like the loan’s term, which is often 15 or 30 years.

Conditions for Full Deduction in Year Paid

A homeowner may be able to deduct the entire cost of mortgage points in the single tax year they were paid, provided a specific set of conditions from the IRS are met. A primary condition is that the loan must be secured by the taxpayer’s main home, which is the residence they live in most of the time. A loan for a second home does not qualify for this immediate deduction.

The payment of points must also be an established business practice in the geographic area, and the amount paid cannot be more than what is generally charged in that region. The points must be computed as a percentage of the loan’s principal amount and be clearly itemized on the closing disclosure or settlement statement.

To qualify, the taxpayer must use the cash method of accounting, where expenses are deducted in the year they are paid. The points must be paid with funds other than money borrowed from the lender. The funds the taxpayer provides at or before closing must be at least equal to the amount of the points charged.

Calculating the Amortized Deduction

When the requirements for a full, immediate deduction are not met, the cost of the points must be spread out over the life of the mortgage. This is common for points paid on a refinanced loan or a mortgage for a second home. The calculation allocates an equal portion of the points to each year of the loan term.

The first step is to identify the total dollar amount of the points paid from the loan’s settlement statement. Next, determine the total number of payments scheduled over the life of the loan, such as 360 months for a 30-year mortgage. Dividing the total cost of the points by the total number of months in the loan term yields the deduction amount per month.

To find the total deduction for a specific tax year, multiply this monthly amount by the number of mortgage payments made during that year. For example, if a homeowner paid $3,600 in points on a 30-year loan, the monthly deduction would be $10. If they made 12 payments during the tax year, their annual deduction would be $120, reported on Schedule A (Form 1040).

Treatment Upon Loan Termination

The handling of unamortized points changes if the loan is terminated before its full term is complete. This commonly occurs when a homeowner sells the property or refinances the mortgage. If the home is sold, any remaining balance of unamortized points can be deducted in full on the tax return for the year of the sale.

A similar rule applies when a homeowner refinances the mortgage with a new lender. The outstanding portion of the original points can be fully deducted in the year the old loan is paid off. This is because the original loan, for which the points were paid, has ceased to exist.

The situation is different if the refinancing is done with the same lender. In this scenario, the undeducted points from the original loan are not deducted all at once. Instead, the remaining balance is added to any new points charged for the refinance, and the combined total is amortized over the term of the new loan.