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.
