The Zero Cost Refinance Program Explained

June 1, 2007 - Realty Times Feature Article by Henry Savage

Immensely popular in some geographic areas, while unheard of in others, the zero cost refinance program deserves a full explanation. In short, qualified borrowers can forego the payment of the traditional closing costs associated with a refinance in exchange for a slightly higher interest rate - usually about one quarter percent. These closing costs include such items as title insurance, county recording fees, appraisal fees, lender underwriting fees, attorney settlement fees, and so forth.

How does it work?

It's quite simple. Wholesale lenders are willing to pay the originating mortgage company a fee in exchange for the higher interest rate. The mortgage company simply pays the borrower's closing costs at the settlement table with this fee, often called a "yield spread premium." The mortgage company keeps the balance as its fee. The borrower doesn't have any out-of-pocket expenses and the closing costs are not rolled into the loan amount because the mortgage company literally pays the closing costs at settlement.

I have been a proponent of the zero cost refi since it became available in the early 1990's, and I have written about the program in the past. Some have argued that by taking a higher interest rate, the borrower will pay more interest over the life of the loan. These misguided souls believe that "buying down" the interest rate through the payment of non-refundable fees and discount points, the borrower will benefit in the long run by paying the lower interest rate.

Conceptually, this is true, but from a practical standpoint, it's nonsense. Let's illustrate:

Typical closing costs, excluding points and origination fees, can vary, depending upon the location of the property. I have offices in Northern Virginia and Charleston, South Carolina. Let's use these areas in our example. On a $300,000 loan, closing costs in Virginia will total about $3,300. The closing costs in Charleston will run closer to $2,300.

As I look at the rates today, I see that I could offer a Virginia homeowner 6.25 percent for a 30 year fixed rate mortgage with no points or closing costs. If the borrower wanted a lower rate and pay the $3,300 in sunken costs, I would offer six percent.

Determining which deal is better is a simple matter of number crunching.

The principal and interest (P&I) payment on a $300,000 loan at 6.25 percent is $1,847. Comparing this with the six percent deal, it would be safe to assume that the borrower would prefer to roll the closing costs into the loan amount rather than pay $3,300 out-of-pocket. So the P&I for a $303,300 loan at six percent is $1,818 - a difference of $29.

Before we try to determine if it makes sense to lose $3,300 in equity to save $29 per month, we have to consider the tax issues. Unlike mortgage interest, closing costs are not tax deductible. My calculator tells me that there would be $553 more in interest paid in the first year under the 6.25 percent, $300,000 deal.

Assuming a 25 percent tax bracket, this borrower would owe $138 less in taxes than the lower rate, high cost deal. Divide the $138 by 12 months, and we find that the zero cost deal will save about $11 more in taxes.

This must be deducted from the $29 difference, creating a true, after tax difference of only $18.

Now the question becomes this: Does it make sense to lose $3,300 in equity in order to save about $18 per month? Simply divide the cost into the savings ($3,300/$18) and we see that it would take 183 months, or more than 15 years to recoup the costs.

Practically speaking, and certainly statistically speaking, folks don't hold loans that long. They either sell or refinance before they would have recouped their cost in the form of a lower payment.

Even if we eliminate the tax savings benefit, $3,300 divide by $29 equals 114 months, or nine and a half years before the borrower would begin to save any money. If the loan is paid off earlier than the break-even point, the borrower has effectively lost money.

Here's another way of looking at it. Since a lower interest rate will curtail principal faster, at what point does the balance of the six percent deal fall below the 6.25 percent deal. My amortization schedule tells me that in the 184th month, the balance of the six percent program falls below the 6.25 percent deal by two dollars, to $212,505.

What if the borrower chooses to take the six percent loan and pay the $3,300 out-of-pocket? The payment difference between six percent and 6.25 percent is $48 per month using the same loan amount of $300,000. But a practical comparison would require us to plug in a number that the $3,300 would have earned had it remained fully invested. Using a mere 3.50 percent simple interest, the borrower would earn almost $10 per month by keeping the money in the bank. Subtract $10 from the $48 and we have a true difference of $38. Divide this number into the $3,300 cost and we still have a break-even point that takes us out to 87 months, or more than seven years, without looking at the tax issues.

Now let's travel south where the closing costs are a bit cheaper. Applying the same calculations, the payback period using the same loan amount, interest rates and assumptions is just under nine years for Charleston residents.

The numbers don't lie, folks. Be wary of loan officers who tout a seemingly low interest rate without full and up-front disclosure of the sunken costs.

One last thing: Closing costs increase as a percentage of the loan amount as the loan amount drops. This makes it more difficult for folks with small loan balances to find a true zero cost refi program. In such cases, ask for mortgage programs that carry no points or origination fees.