The best way to decide whether you
should pay points or not is to perform a break-even analysis. This is
done as follows:
- Calculate the cost of the points.
Example: 2 points on a $100,000 loan is $2,000.
- Calculate the monthly savings on the
loan as a result of obtaining a lower interest rate. Example: $50
per month
- Divide the cost of the points by the
monthly savings to come up with the number of months to break
even. In the above example, this number is 40 months. If you plan
to keep the house for longer than the break-even number of months,
then it makes sense to pay points; otherwise it does not.
- The above calculation does not take
into account the tax advantages of points. When you are buying a
house the points you pay are tax-deductible, so you realize some
savings immediately. On the other hand, when you get a lower
payment, your tax deduction reduces! This makes it a little
difficult to calculate the break-even time taking taxes into
account. In the case of a purchase, taxes definitely reduce the
break-even time. However, in the case of a refinance, the points
are NOT tax-deductible, but have to be amortized over the life of
the loan. This results in few tax benefits or none at all, so
there is little or no effect on the time to break even.
If none of the above makes sense, use
this simple rule of thumb: If you plan to stay in the house for less
than 3 years, do not pay points. If you plan to stay in the house for
more than 5 years, pay 1 to 2 points. If you plan to stay in the house
for between 3 and 5 years, it does not make a significant difference
whether you pay points or not!
Zero-Point/Zero-Fee Loans
Whatever happened to the conventional
wisdom of waiting for the rates to drop 2% before refinancing?
You have a 30-year fixed loan at 8.5%.
A loan officer calls you up and says they can refinance you to a rate
of 8.0% with no points and no fees whatsoever.
What a dream come true! No appraisal
fees, no title fees and not even any junk fees! Is this a deal too
good to pass up? How can a bank and broker do this? Doesn't someone
have to pay? Whose money is being used to pay these closing costs?
No––this is not a scam. Thousands
of homeowners have refinanced using a zero-point/zero-fee loan. Some
refinanced multiple times, riding rates all the way down the curve in
1992, 1993 and, more recently, in 1996. Some homeowners used
zero-point/zero-fee adjustable loans to refinance and get a new teaser
rate every year.
The way this works is based on rebate
pricing, sometimes also known as yield-spread pricing, and sometimes
known as a service-release premium. The basic idea is that you pay a
higher rate in exchange for cash up front, which is then used to pay
the closing costs. You will pay a higher monthly payment––so the
money is really coming from future payments that you will make.
You can also think of this as negative
points! For example, a 30-year fixed loan may be available at a retail
price of :
8.0% with 2 points or
8.25% with 1 point or
8.5% with 0 points or
8.75% with -1 point or
9% with -2 points
On a $200,000 loan, the loan officer
can offer you 8.75% with a cost of -1 point, which is a $2,000 credit
towards your closing costs. A mortgage broker can use rebate pricing
to pay for your closing costs and keep the balance of the rebate as
profit.
What are the benefits of a
zero-point/zero-fee loan?
The main benefit is that you have no
out-of-pocket costs. As a result, if the rates drop in the future, you
could refinance again even for a small drop in rates. So if you
refinanced on the zero-point/zero-fee loan to get a rate of 8.75% and
if the rates drop 1/2%, you can refinance again to 8.25%. On the other
hand, if you refinanced by paying 1 point and got a rate of 8.25%, it
may not make sense to refinance again. Now, if the rates drop another
1/2%, a zero-point/zero-fee loan can drop your rate to 7.75%, whereas
if you paid points, you may have to do a break-even analysis to decide
if refinancing will save you money.
The zero-point/zero-fee loan eliminates
the need to do a break-even analysis since there is no up-front
expense that needs to be recovered. It also is a great way to take
advantage of falling rates.
Some consumers have used
zero-point/zero-fee loans on adjustable loans to refinance their adjustable
every year and pay a very low teaser rate.
What are the disadvantages of a
zero-point/zero-fee loan?
The main disadvantage is that you are
paying a higher rate than you would be paying if you had paid points
and closing costs. If you keep the loan for long enough, you will pay
more––since you have higher mortgage payments. In the scenario
where you plan to stay in the house for more than 5 years, and if
rates never drop for you to refinance, you could wind up paying more
money. If, on the other hand, you plan to stay at a property for just
2-3 years, there really is no disadvantage of a zero-point/zero-fee
loan.
Whose money is it?
Since you are being paid
"cash" up-front in exchange for a higher rate, it really is
your own money that will be paid in the future through higher
payments. Investors who fund these loans hope that you will keep the
loans for long enough to recoup their up-front investment. If you
refinance the loans early, both the service and the investor could
lose money.
To summarize, zero-point/zero-fee loans
in many cases are good deals. Make sure, however, that the lender pays
for your closing costs from rebate points and NOT by increasing your
loan amount. So if your old loan amount was $150,000, your new loan
amount should also be $150,000. You may have to come up with some
money at closing for recurring costs (taxes, insurance, and interest),
but you would have to pay for these whether you refinanced or not.
Zero-point/zero-fee loans are
especially attractive when rates are declining or when you plan to
sell your house in less than 2-3 years.
Zero-point/zero-fee loans may not be
around forever. Lenders have discussed adding a pre-payment penalty to
such loans, however few lenders have taken steps to implement such a
measure.
