THE BASIS POINT

How Do You Select The Right Loan In 2007?

Now that you’ve settled into your routine for the new year, we wanted to give you some tax tips to help you understand and optimize your 2006 filing, and some tips for evaluating costs and rates of your existing or new loans. New loans are used for purchasing a new home, getting cash out of your home, consolidating two loans, changing your loan term, and of course, lowering your rate – which looks like a strong possibility in 2007.

The economy still hasn’t fully reacted to the housing shakeout that began last year. As the current economic cycle matures, slower and lower home sales have affected many industries beyond just real estate (construction, specialty retail, etc.), which ultimately slows economic growth. This is one reason why much of Wall Street thinks Fed will cut rates in the second quarter or second half of 2007 to stimulate growth. Nobody knows precisely when, but the possibility of lower rates raises important questions for anyone considering a loan in the near future.

Should You Pay Loan Points Right Now?
It’s always worth seeing if you can save money on your loan by “buying your rate down,” also known as paying points. One point is equal to 1% of a loan amount, but you can buy your rate down using any fraction of a percent that you want in order to lower your payment. As rates rose in 2006, rate buy-downs were a good option for lowering payments. But if you pay points for a lower rate right now and rates drop later in the year, you’d lose money if you refinanced at that time. Here’s how to figure out if you’d actually save money by paying points:

Let’s say you’re getting a 5-year fixed interest-only loan for $500,000. You could get a zero-points rate at 6%, which has a $2500 payment. Or you could pay one point to get a rate of 5.625% and a payment of $2343 – so you’d pay $5000 out front to save $156 per month. Your monthly savings would pay the $5000 back in 32 months, and then you’d benefit from that lower payment for 28 more months, which would save you a total of $4368 by the end of the loan’s 5-year fixed term.

That’s a good deal. But only if you know for sure that you’re keeping that loan for five years. As we anticipate lower rates this year, it’s probably better to take a zero-points deal now so you won’t have to take a loss on points if you refinance later in the year.

Do Prepayment Penalties Make Sense?
The logic above also goes for a “prepayment penalty,” which is a fee assessed for paying a loan off early (by refinancing that loan or selling your property). Sometimes borrowers use a prepayment penalty to lower their rate. But the penalty periods are anywhere from one to three years, and given the refinancing opportunities that may come later in 2007 – even on a loan you may be closing now – you may be better off with a loan that has no prepayment penalty.

Using the $500,000 loan example above, let’s say you took a three-year prepayment penalty to lower your rate by .375%. This would save you $156 per month, but if you refinanced or sold your home within that three-year period, you’d have to pay the prepayment penalty. This fee is usually 6 months of interest which, in this example, is $15,000. Obviously, the math just doesn’t work in this case. But it can work in certain scenarios, so again, it’s always worth checking when you’re pricing your loan.

Are You Ready For Tax Season?
Beyond the points and prepayment penalty basics above, you should also know that both of these items are tax deductible. If you paid points or a prepay in 2006, be sure to claim these deductions (note: deductions for points on refis are spread out over time).

Also, here’s a few things to get ready for tax season: IRS form 1098 will arrive from your lender(s) – this is the form that shows the amount of interest you paid in 2006; copies of property tax bills paid in 2006; copies of settlement statements from loans closed in 2006 – there are usually a couple line items on settlement statements that can also be deducted.

As you get ready for filing your 2006 taxes, you may also want to see our property tax deduction overview from last year. It’s mostly the same this year.