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.
