By Dian Hymer
Looking for some income tax-relief? Why not consider buying a home? Homeowners who itemize deductions can deduct the cost of property taxes and mortgage insurance paid on their primary residences (with some restrictions).
First-time buyers are often low-cash-down buyers. A larger mortgage means more interest to write off, but there's a wrinkle in this financing picture. Lenders usually charge mortgage insurance (MI, also call Private Mortgage Insurance or PMI) when the mortgage amount exceeds 80 percent of the property value. Mortgage insurance protects the lender in case the borrower stops making mortgage payments.
The cost of mortgage insurance varies with the loan program and the payment plan, but it can add the equivalent of 1/4 percent or more to the monthly payment. But MI isn't interest, so it can't be deducted.
There are ways to avoid MI when the mortgage exceeds 80 percent. One way is to break one mortgage, say for 90 percent of the purchase price, into two: a first mortgage for 80 percent and a second mortgage for 10 percent of the price. Many lenders won't charge MI with this financing arrangement.
Another way around MI with a high loan-to-value mortgage is to use a portfolio lender. Portfolio lenders generate loans to hold in the lender's own portfolio, not to sell to other investors. Many portfolio lenders self-insure for MI. To cover the cost of self-insuring, the lender charges the borrower a higher interest rate which is tax deductible.
Most conventional home mortgages are amortized loans. The borrower makes monthly payments, part of which pays the interest owed and part of which pays back principal (the amount borrowed). With a 30-year fixed rate fully amortized loan, the monthly payments pay back the principal completely over 30 years.
During the early years of a 30-year amortized loan, most of each monthly payment goes to pay interest. Very little principal is paid back. For example, at the end of the first year of a 30-year fixed mortgage at 8 percent, less than 1 percent of the principal is repaid.
The longer you pay on an amortized loan, the more of each monthly payment goes to pay back principal. Less of each monthly payment goes toward interest. You lose some of your interest write off as you build equity in the property.
First Time Tip: With an interest-only loan, all of each monthly payment goes to pay interest. None of the principal is repaid. An interest-only loan gives you the maximum tax write-off. But, at the end of five years of paying on an interest-only loan, you still owe the amount you originally borrowed.
Several lenders offer interest-only loans. If you're looking for the maximum tax write-off, combine an interest-only first mortgage for 80 percent of the purchase price with a 10 percent second mortgage. Most conventional second mortgages have amortized payments. But if you can find sellers who'll carry a second mortgage for you, they might be willing to accept interest-only payments.
Be aware that most conventional interest-only mortgages require amortized payments at some time. Often, they're interest-only for the first five years. After that they convert to an amortized loan that is fully paid off by the end of the loan term.
The Closing: Keep in mind that in order to get the write-off you must first pay the interest. You don't get something for nothing. Leveraging your home for the maximum write-off isn't the best strategy for everyone. Consider your short term and long range financial goals. You may want to consult a financial advisor.
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