Should I pay points? Does a zero-point/zero-fee loan
really exist?
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.
