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.
