The best way to decide whether you should pay points or not is to perform a break-even analysis. This is done as follows:
- 1. Calculate the cost of the points. Example: 2 points on a $100,000 loan is $2,000.
- 2. Calculate the monthly savings on the loan as a result of obtaining a lower interest rate. Example: $50 per month
- 3. 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 home for longer than the break-even number of months, then it makes sense to pay points, otherwise it does not.
- 4. The above calculation does not take into account the tax advantages of points. When you are buying a home 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, consider this simple rule of thumb: If you plan to stay in the home for less than 3 years, do not pay points. If you plan to stay in the home for more than 5 years, pay 1 to 2 points. If you plan to stay in the home 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 percent before refinancing?
You have a 30-year fixed rate loan. A loan officer calls you up and says you can refinance to a rate 0.5% lower than your current rate, and there will be no points, no appraisal fee, no title or escrow fees, etc. A No Cost loan, with a lower rate, lower payment and your loan balance stays the same.
Is this a deal too good to pass up? How can a bank and broker do this? Doesn't someone have to pay? Who?
This is not a scam. Thousands of homeowners have refinanced using a zero-point/zero-fee loan. Some refinanced multiple times in a single year. Some homeowners used zero-point/zero-fee adjustable loans to refinance and get a new teaser rate every year.
This works due to rebate pricing, also known as yield-spread pricing or service-release premium pricing. You pay a higher rate in exchange for cash up front, which is then used to pay the closing costs. You are financing the closing costs by paying a higher rate. A zero point loan, with the borrower paying the closing costs would be 0.25 to 0.5% lower than the no cost loan.
On a $200,000 loan, the loan officer can offer you a rate with a cost of -1 point (rebate), 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. A no cost loan would need to have enough rebate points to cover all your closing costs, plus his profit margin.
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 lower rate and then the rates drop another 1/2 percent, you can refinance again.
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.
What are the disadvantages of a zero-point/zero-fee loan?
The main disadvantage is that you'll pay a higher rate than you would, had you paid points and closing costs. If you keep the loan long enough, you'll pay significantly more due to the higher rate. In a scenario where you plan to stay in the home for more than five years, and if rates never drop (no refinance opportunity), you could end up paying more money. If, on the other hand, you plan to stay in the home less than five years, there is likely no disadvantage with a zero-point/zero-fee loan.
Whose money is it?
The Lender advances the initial up front rebate points. Since you are receiving the cash in exchange for a higher rate, you will eventually pay back the rebate points. You're essentially financing the closing costs. Investors who fund these loans hope that you will keep the loans long enough to recoup their up-front investment. If you refinance the loans early, both the lender 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 home 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. Read the Pre-Payment clause in your Note, before signing the final loan docs. As a counter measure, some lenders will prohibit your mortgage broker from refinancing your mortgage within the first 6-12 months.
