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Should I pay points? Does a zero-point/zero-fee loan really exist?
The best way to decide whether you should pay points 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 you still can't deside whether or not to use points, 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?
Imagine this scenario. A home owner has a 30-year fixed loan at 8.5%. A loan officer calls and
says the owner can refinance at 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! 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 homeowners have refinanced multiple
times, riding rates all the way down the curve in 1992, 1993 and, most
recently, in 1996. Some homeowners used zero-point/zero-fee adjustable
loans to refinance and get a new teaser rate every year.
This works based on a principle called rebate pricing. Rebate pricing is commonly known as
yield-spread pricing and is sometimes known as a service-release premium.
The basic idea is that when a borrower pays a higher rate in exchange for cash up
front, the cash can then be used to pay the closing costs. The borrower will then pay a
higher monthly payment––so the money is really coming from
future payments that will be made.
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 a 8.75% with a cost
of -1 point, which is a $2,000 credit towards closing costs. A
mortgage broker can use rebate pricing to pay for 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 no out-of-pocket costs. As a result,
if the rates drop in the future, one could refinance again for a
small drop in rates. For example, if one refinanced on the zero-point/zero-fee
loan to get a rate of 8.75%, and the rates drop 1/2%, the borrower can
refinance again to 8.25%. On the other hand, if one refinanced by paying
1 point and got a rate of 8.25%, it may not make sense to refinance
again. If the rates were to drop another 1/2%, a zero-point/zero-fee loan
can drop the rate to 7.75%, whereas by paying points, the borrower may have to
do a break-even analysis to decide if refinancing would save them 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 of zero-point/zero-fee loans is that the borrower is paying a higher rate than they
would pay if they had paid points and closing costs. The longer that one keeps the loan, the more they will eventually pay since they will have
higher mortgage payments. In the scenario where the borrower plans to stay in the
house for more than 5 years (provided that the rates never drop low enough to
refinance), the borrower could wind up paying more money. However, if the borrower
plans to stay at a property for just 2-3 years, there really is no
disadvantage of a zero-point/zero-fee loan. 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.
Whose money is it?
Since cash is being paid up-front in exchange for a
higher rate, the money belongs to the borrower as it will be paid in the future
through higher payments. Investors who fund these loans hope that the borrower
will keep the loans long enough to recoup their up-front investment.
By refinancing 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.
Be certain that the lender pays for closing costs from
rebate points and NOT by increasing the loan amount. For example, if the old
loan amount was $150,000, the new loan amount should also be $150,000.
The borrower may have to come up with some money at closing for recurring costs
(taxes, insurance, and interest), but these fees would most likely have to be paid
whether you refinanced or not.
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.
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