The home mortgage interest tax deduction allows a homeowner to deduct the mortgage interest paid on the primary residence and one second home.

Buying a Home

The interest paid on the first one million in loans to purchase a primary residence and/or second home may be deductible.

Generally, points paid at closing for the purchase of a primary home are deductible in the year of purchase, even if the seller pays them. The interim interest paid on the loan at closing is also deductible subject to the one million dollar loan limit.

Points paid to purchase a second home must be amortized over the term of the loan.

It is important to note that on a purchase transaction, the points currently deductible must not exceed the amount of the down payment provided by the borrower. The points over the down payment amount must be amortized over the loan term. Closing costs for services such as title searches and appraisals are not deductible.

As an example, a borrower puts down $10,000 on a $100,000 home, and pays $2,000 in points and $1,000 in other closing costs. The borrower would be able to deduct the full $2,000 in points the first year. The other $1,000 in acquisition costs are not deductible.

Refinancing and Taxes

You can still deduct the interest paid on your primary or second homes when you refinance, but the points paid on the refinance must be amortized over the term of the new loan. Any unamortized points on the old loan being refinanced are currently deductible.

If you refinance by getting a new loan to payoff an old loan of equal value you will be subject to the standard first mortgage restrictions of up to $1 million. If you decide to withdraw a portion of your equity by refinancing (termed a "cash-out" refinance) you will have different rules.

Home equity indebtedness is indebtedness (other than acquisition indebtedness) secured by a principal or second residence. Generally, home equity indebtedness is deductible on loans up to $100,000.

An example of a cash-out refinance: a homeowner has a $150,000 first mortgage. He decides to refinance to get a lower interest rate and get additional cash for his child's college tuition. He chooses a new loan amount of $200,000. The additional $50,000 would be treated as home equity debt. Since the home equity debt is less than $100,000, it is fully deductible.

In other words if you have sufficient equity, you may withdraw up to $100,000 of equity from your home and still deduct the interest. Second mortgages or equity lines are subject to the same $100,000 limitations.

Other Considerations

Often prepaying a mortgage in today's low interest rate environment doesn't make financial sense due to tax laws benefiting homeowners.

Since mortgage interest is deductible, the effective after-tax interest rate is reduced below the mortgage note's interest rate. As an example, if the note interest rate is 8% the effective interest rate for someone in the 35% tax bracket is reduced to about 6%. In this example, prepayments to reduce the loan's principal saves only 6 percent in effective after tax interest rate terms.

However, if your investments do not yield returns in excess of the after tax effective rate on your home mortgage loan you may be better off prepaying your loan.

Take a closer look at your 401(k), IRA's and other investment vehicles to see if an additional monthly investment might be a better option.