"In your article about
paying points, you said that the additional cash drain might be avoided by
rolling the points into the loan. If there is no cash outlay, isn't the payment
of points a no-brainer?"
Not necessarily. Although financing
the points eliminates the cash drain, it remains the case that you must stay in
the deal some minimum period of time to make it worth while. If you pay off your
loan very quickly, the larger loan balance that you must repay will wipe out the
savings from lower monthly payments.
Here is an example. A borrower
selecting a 30-year
fixed-rate mortgage is offered a choice between 5% with 4 points, and 6% with no
points. Assuming a $100,000 loan, the 6% loan has a payment of $600. Financing
the 4 points on the 5% loan increases the loan amount to $104,167, but because
of the lower rate the payment is only $559.
While the borrower saves $41
every month, the loan balance is larger on the 5% loan because it includes the
points. If the loan were paid off after the first month, financing points would
be a loser. The $41 saving over one month would be swamped by the $3942
difference in the balance.
Over time, however, the $41
per month saving builds up while the difference in the loan balance shrinks. A
useful number for the borrower is the break-even period. How long must the
low-rate mortgage with higher points be retained before the benefit exceeds the
cost? The shorter the break-even period, the more advantageous is the
lower-rate loan with points. This is the same question that should be asked when
the borrower pays the points in cash, although the answer ordinarily will not be
Some break-even periods are
shown below for different investment rates and income tax rates. The first
number in each cell assumes the borrower pays the points in cash while the
second number assumes the points are financed. These numbers are derived
from my calculator 11a, The
Costs and Benefits of Paying Points on Fixed-Rate Mortgages. They assume a purchase transaction (the tax treatment of
points is slightly different on a refinance).
Periods in Months on 30-Year Mortgages: 6% at 0 Points Versus 5% at 4
Tax Rate 0%
Tax Rate 28%
Tax Rate 40%
The table indicates that in most
cases financing the points is less advantageous than paying them in cash.
The exception is where the investment rate -- the rate the borrower can earn on
his money -- is high and the tax rate is low.
break-even periods when points are financed assume that financing the points
does not raise any other costs to the borrower. This would be true under the
following conditions. First, the increase in the loan amount cannot bring it
from an amount below $300,700 to an amount above that. Rates are higher on loans
exceeding $300,700 because this is the maximum size loan eligible for purchase
by the two government-sponsored entities, Fannie Mae and Freddie Mac.
Second, the increase in the loan
amount cannot bring it into a higher mortgage insurance premium category.
Mortgage insurance premiums are based on the ratio of loan amount to property
value, with 3 premium categories: 80-85% (the lowest), 85-90%, and 90-95%.
Third, if you are refinancing, the
new loan cannot exceed the outstanding balance on the old loan plus closing
costs including points. If the new loan is larger than that, it is classified as
a "cash-out refi" which may carry a higher rate.
If the larger loan that
results from financing the points triggers an increase in the interest rate or
the mortgage insurance premium, you don�t want to do it.
"I was offered a
'no-points and no-closing costs' loan on a refinance, but when I received the
documents I found that the closing costs were included in the loan balance�Is
The practice is all too common, but
I would not use the word "customary" to describe it. That word
"customary" suggests that the practice is OK when in fact it is
something of a scam. You are not getting a "no-closing cost" loan
because you are paying the closing costs. The fact that you are borrowing the
money to do it does not change this central fact.
That doesn't mean there is anything
inherently wrong with financing closing costs. The scam is in misleading you
into believing that you are getting something for nothing -- a lower rate on
your loan, with no cash outlay. You must repay money borrowed to pay closing
costs, just as you must repay money borrowed to pay points, as discussed
Copyright Jack Guttentag
Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.
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