Something in the tax law called the at risk rules limits the amount of your tax deductions depending on how much money you have at risk in the investment. The IRS will not allow you to deduct investment property expenses against other income (such as your salary or wages) unless you have equity in the property or you are personally liable for the financing.
Points are confusing because there are two different kinds. Both kinds are calculated by starting with the amount of your loan. One point equals 1% of your loan. A quote of "three points" for a US Dollars 100,000 loan means the points will be 3% of US Dollars 100,000, or US Dollars 3,000. That is fairly simple. It gets complicated when you want to know what the points are for. One kind, called origination points, is a lender fee to cover certain expenses and additional profit for the lender. On a typical commercial loan, the origination points will be 0.5%–1% of the loan. This is very negotiable, but most lenders will not waive it entirely. The other kind of points is a prepaid interest, used to buy down your interest rate on the loan, which means reducing it below the typical quoted rate. This is entirely at your option. The lender cannot force you to pay this kind of points.
Lenders all include different expenses within their origination points. There is no rule regarding what is covered. One might charge you 0.5% of the loan, but you will also have to pay for the lender's attorney's fees, appraisal, and survey. Another might charge 1% of the loan, but with no additional expenses. You cannot compare the loans until you know what your additional expenses will be. That is why you always have to ask each lender every time, even if you use the same lender for several different loans. Policies can change while you are not looking!
Prepayment points, usually simply called "points," are a fee you pay in order to obtain a reduced interest rate. In effect, you are paying some of your interest in advance, so the lender is willing to make your loan at a lower rate. By making your brother pay five points in exchange for reducing the interest rate on the US Dollars 100 loan, you can take the US Dollars 5 he pays up front, put it in a bank, and earn interest on it for a whole year.Your brother, on the other hand, had to take that US Dollars 5 out of the bank in order to pay you when the loan was made, which means he also loses the interest he was earning on it.
To make matters more complicated, suppose your brother found a US Dollars 100 bill in an old trousers pocket and decided to repay his loan to you after only six months. You received US Dollars 5 when the loan was made. That is your money to keep, no matter what. At the end of six months, your brother will owe one half year's interest on US Dollars 100 at 5% interest, or US Dollars 2.50. He will pay you US Dollars 102.50. So, you receive a total of US Dollars 7.50 for a six-month loan on US Dollars 100. That is an annual interest rate of 15%, without even taking into account the benefit of getting US Dollars 5 of the money up front. This is a good example of why prepayment points rarely make sense for people who will keep their loans for five years or less. The numbers just do not work out very well for the borrower.
The exception is when the seller pays the points for you. This is not uncommon. If the seller pays the points, then it probably makes no difference to you. Why would a seller pay your points, instead of just reducing the sales price? Remember, lenders will loan you a percentage of the sales price or the appraised value, whichever is less. If the seller reduces his or her sales price, that also reduces your loan amount. You might be willing to have a higher sales price with a larger loan, but at a lower interest rate.
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