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September 2002, Revised August 17,
2004
"Another expert recommends refinancing
using a no-closing-cost option. His reasoning is that on a refinance, any points
paid upfront must be taken as a tax deduction over the life of the loan. This is
in contrast to a purchase transaction, on which points can be deducted in their
entirety in the year of purchase. This seems perfectly logical to me, but some
things you have written suggest that you don�t entirely agree. Is that
true?"
Points are an upfront charge expressed as a
percent of the loan. One point on a $100,000 loan is a charge of $1,000. Lenders
charge points on low-interest rate loans and pay them on high-rate loans. For
example, on a 30-year fixed-rate mortgage, they might quote 5.75% with 2 points,
6.25% with zero points, and 7% with a 2-point rebate. A "no-closing cost
option" is one where the rebate covers all closing costs. The expert you
cite recommends this option.
He is quite right that the tax treatment of
points is less favorable on a refinance than on a purchase transaction.
Nonetheless, no-cost refinances make sense only for borrowers who expect to hold
their mortgages for only a few years. A borrower with a longer time horizon, and
who has the cash to pay settlement costs, ought to avoid the no-cost option.
Lenders price rebates high. Their quid pro
quo for a rebate is a high interest rate but lenders set this rate on the
assumption that they won�t enjoy it very long. The average life of
high-interest-rate loans is short. A borrower with a long time horizon thus gets
a bad deal. It is akin to a healthy person buying life insurance from a company
that insures diabetics and smokers, and prices its insurance accordingly.
But the proof of the pudding is in the
numbers. The critical number for potential borrowers is the "break-even
period" (BEP) for a no-cost loan, relative to the same loan with a lower
rate on which the borrower pays the costs. Over periods shorter than the BEP,
the no-cost loan has lower costs. Beyond the BEP, the no-cost loan has higher
costs.
I have two BEP calculators, 11a for fixed-rate loans and 11b for adjustables. The calculators factor in the
tax benefits on interest and on points, the reduction in loan balance, and
interest loss on monies used to make monthly payments and pay points.
To illustrate, on July 10, I shopped
Eloan.com, a very competitive web site, for a 30-year fixed-rate loan that
included a no-cost version at 7%. I used the calculator to determine the BEP
relative to a 6.375% version on which the borrower paid settlement costs,
including 4/10 of a point. To make the comparison as favorable as possible to
the no-cost option, I assumed the highest possible tax rate of 39.1%.
The BEP turned out to be 40 months on a
purchase transaction and 44 months on a refinance. Over periods this short, the
difference in tax treatment between a refinance and a purchase does not carry
much weight. The reason is that a refinancing borrower who pays off his loan in
full can take the entire remaining tax deduction in the payoff year. If payoff
occurs in the fourth year, the loss from deferral of the deduction is small.
At lower tax rates, the BEP is even shorter.
At a 15% rate, it is 31 months on a purchase and 32 months on a refinance.
In my view, the no-cost option is a clear
winner for only one category of refinancing borrower. This is the borrower who
intends to sell his house within a few years, and has a mortgage with an
interest rate above the rate available in the market on a no-cost loan.
In recent years, the no-cost option has also
worked well for borrowers who have refinanced every time the market has dropped
to a new low. Through successive refinancings, these borrowers have kept the
life of their loans short � to this point. With the benefit of hindsight, this
was a good strategy to have adopted 5 years ago. When interest rates start to
rise, however, their most recent no-cost refinancing will not turn out as well.
November 1, 2002 Postscript
"No-cost" does not
mean zero outlays at closing. Borrowers should always expect to pay per
diem interest, which is interest from the day of closing to the first day of the
following month. On a refinance, they will also pay interest from the
first of the month to the closing day. Borrowers will also have to pay for
escrows, though on a refinance they will get credit for escrows held by the old
lender. In addition, they will pay for homeowners insurance and any transfer
taxes.
August 17, 2004 Postscript
The calculations shown above assume that the settlement costs that
the borrower would pay in cash without a no-cost mortgage are the same as the
settlement costs the borrower pays in the interest rate with a no-cost mortgage.
In fact, this may not be the case, for reasons explained in
No-Cost Mortgages.
Copyright Jack Guttentag 2004 | 
