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.