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Making Sense of Zero Cost Refinance Programs...

By
Real Estate Agent with Real Living Hagan Realtors | Pinehurst ~ Southern Pines, NC

Wildly popular in some geographic areas... Virtually unheard of in others, the zero cost refinance program can sometimes be misunderstood, and it's the the borrower who is most often affected.

Simply put, qualified borrowers 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.

Available since the early 1990's zero cost refinance programs have many proponents. And although some have argued that by taking a higher interest rate, the fact is the borrower will pay more interest over the life of the loan. Some misguided souls believe that "buying down" the interest rate through the payment of non-refundable fees and discount points, they will benefit in the long run by paying the lower interest rate.

While conceptually, this is true, but from a practical standpoint, it's nonsense.

Typical closing costs, excluding points and origination fees, can vary, depending upon the location of the property and on a $300,000 loan; closing costs typically range from $2,300 to $3,300 with an interest rate of 6.25% 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, they would likely be able to get 6%.

Which is better is simply a matter of crunching the numbers.

The principal and interest (P&I) payment on a $300,000 loan at 6.25 % is $1,847. Comparing this with the 6% 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 Principal and Interest for a $303,300 loan at 6% is $1,818 for 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. The calculator tells us 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, most 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.

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 6% percent program falls below the 6.25% deal by two dollars, to $212,505.

What if the borrower chooses to take the 6% percent loan and pay the $3,300 out-of-pocket? The payment difference between 6% percent and 6.25% 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.

Numbers don't lie... Just 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 refinance program. In such cases, ask for mortgage programs that carry no points or origination fees.

Visit PinehurstHomeTeam.com for information on other real estate related matters. 

Thank you for your interest and the privilege of serving you!

With our highest regard,

Wayne and Lynda Gomillion
"The Pinehurst Home Team"

The friendship and referrals of those we serve is the foundation of our success.

 

Author Henry Savage. Posted to our Real Estate Update. Copyright © 2007 Realty Times®. All Rights Reserved.

Comments (1)

Katrina Madewell
Charles Rutenberg Rlty- More than 5,000 agents(813) 777-1196 - Tampa, FL
Tampa FL Homes for sale | Tampa Bay - (813) 777-1196
WOW in FL it's more than that... you know how high those closing cost can get... (they aren't getting any cheaper either)
Jun 19, 2007 05:41 PM