The ‘No Closing Cost’ Option

Question: I’ve heard about refinancing using a no-closing-cost option. The reason this is recommended is that on a refinance, any points paid upfront must be taken as a tax deduction over the life of the loan. This contrasts with 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?

Answer: 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 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 put a high price on rebates. 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 gets a bad deal.

But the proof is in the numbers. The critical number for potential borrowers is the BEP, or “break-even period,” 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 it, the no-cost loan has higher costs.

I have two BEP calculators at www.mtgprofessor.com (11a for fixed-rate loans and 11b for adjustables). The calculators factor in the tax benefits on interest and 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 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.

The no-cost option is a clear winner for only one category of refinancing borrower: one who intends to sell his house within a few years, and has a mortgage with an interest rate above that 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 five years ago. When interest rates start to rise, however, the most recent no-cost refinancing will not turn out as well.

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*--* Average Mortgage Rates and Indexes Weekly survey of 60 Southland lenders as of Sept. 19, 2002 Latest week One week previous Six months previous Rates for loans up to $300,700 30-year fixed 5.82%/1.41 pt 5.82%/1.70 pt 6.87%/1.44 pt 30-year ARM 3.37%/1.00 pt 3.37%/0.96 pt 3.98%/0.75 pt start rate 15-year fixed 5.32%/1.08 pt 5.32%/1.37 pt 6.41%/1.43 pt Rates for loans over $300,700 30-year fixed 6.17%/1.38 pt 6.18%/1.55 pt 7.10%/1.44 pt 30-year ARM 3.60%/0.85 pt 3.60%/0.85 pt 4.12%/0.84 pt start rate 15-year fixed 5.68%/1.23 pt 5.69%/1.46 pt 6.73%/1.37 pt FHA or VA 6.38%/0.76 pt 6.45%/0.85 pt 7.13%/1.55 pt mortgage Average / points CALVET 30-year 6.00%/0.00 pt 6.00%/0.00 pt 6.50%/0.00 pt 6-month LIBOR 1.770% 1.830% 2.300% 1-year 1.730% 1.780% 2.580% Treasury bill 6-month 1.670% 1.680% 2.120% Treasury bill 6-month CD 1.720% 1.780% 2.300% Prime rate 4.750% 4.750% 4.750% 11th District June ’02 Jan. ’02 cost-of-funds July ’02 2.821% 2.847% 3.074% Compiled by National Financial News Services

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