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 adjustables 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 servicer 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.
