By Jeff Brown
These days nearly 80 percent of mortgage applications are for refinancing, according to the Mortgage Banker’s Association.

It’s not surprising. The BankingMyWay.com survey shows 30-year fixed rate mortgages averaging a stunningly low 5.05 percent. Homeowners with older loans, especially those with risky adjustable-rate mortgages, can reap terrific savings by locking in today’s rock-bottom rates.

But refinancing can give you some extra work at tax time, since therules on deducting "points" are tricky.

Points are up-front interest charges, with each point equaling 1 percent of the loan amount. Paying one, two or three points can get the borrower a slightly lower interest rate, reducing the monthly payment. Bank of America (Stock Quote: BAC), for example, quotes a zero-point loan at 5.375 percent and a two-point one at 4.5 percent.

Points are worth paying if you’ll have the loan long enough for the savings in payments to offset the cost of the points. Use the BankingMyWay.com Mortgage Loan Calculator to compare payments on loans with different rates.

Points paid on an original mortgage, one used to buy the home, can be deducted the year they are paid, just like interest in the regular monthly payments. If you took out a $200,000 loan and paid three points, or $6,000, the deduction would save you $1,500 in taxes, assuming a 25 percent tax bracket. However, be careful about terminology. Only points representing pre-paid interest are deductible, not ones used for other closing costs.

Keep in mind though that points paid on a refinancing cannot be deducted all at once. Instead, they must be spread over the life of the loan. If the example above involved a refinancing to a 30-year loan, the $6,000 in points would have to be spread out over three decades. You could deduct just $200 in points a year, saving a meager $50 a year in taxes.

But there are exceptions. If you get rid of the loan before the full term ends, points that have not yet been deducted can be claimed all at once.

In other words, if you had the 30-year loan for 10 years and then paid it off by selling the home or refinancing again, you would have deducted only a third of the $6,000 in points that were paid 10 years earlier. So you could claim the remaining $4,000 in the year you retire the loan.

Also, if part of the new loan is used to improve the home, points attributable to that can be deducted all at once. For example, if a third of the new loan was for improvements, a third of the points could be deducted that year, in addition to that year’s share of the remaining two-thirds spread over the loan’s life.

What if retiring the old mortgage involves paying points to refinance again? Then you can deduct the previously unclaimed points from the old loan in one year, while spreading the points for the new one over the full term.
Find all the point-deduction details in IRS Publication 936.

Even though it is a shame to overlook a tax deduction, or to have a hassle with the IRS because you claimed all the points at once when you weren’t entitled to, the tax treatment of points is not the key factor in deciding whether to pay them or not. The long-term savings through reduced monthly payments is what matters most.

And, of course, it always pays to find the cheapest mortgage – cheapest when both points and interest rate are taken into account. Use the shopping tool at BankingMyWay.com to locate the best deals.

—For more ways to save, spend, invest and borrow, visit MainStreet.com.