Mortgage Q&A: Slightly higher rate has a plus

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With interest rates remaining at historic lows, I want to reiterate my long-standing position that homeowners considering a refinance should seriously consider choosing a slightly higher interest rate to avoid the typically high cost of refinancing.

It is true that over time, points and closing costs are eventually recouped through a lower interest rate. But the payback period often is long, and there’s never a 100 percent certainty that the borrower will hold the loan long enough to negate those costs.

This is especially true for homeowners seeking a 15-year fixed-rate mortgage. I want to revisit a conversation I recently had with a client who agreed to take out a zero-cost refinance, even though he was leaning toward paying closing costs in order to get a lower rate. Let’s do some number crunching.

My borrower is deciding whether to refinance his $500,000 mortgage to a 15-year fixed-rate loan with a 4.25 percent rate and no closing costs, or a 4 percent rate with about $4,800 in closing costs that he would pay out of pocket. He plans on staying in the house and never refinancing again.

Which deal is better?

Most would think that paying the $4,800 in upfront fees to secure a 4 percent rate over 15 years is the way to go. The numbers suggest otherwise. I did some calculations and came up with the following numbers.

  • The payment difference between a 4.25 percent and 4 percent loan is $63 per month. Over the 15-year period, the borrower saves $11,340 by taking the lower rate.
  • Because the upfront cost is $4,800, we must subtract this cost from the total payment savings of $11,340. The savings shrinks to $6,540.
  • Because the borrower had planned to pay the $4,800 out of pocket, it is money that disappears. Under the zero-cost program, he can retain the $4,800 and invest it over the long term. Even though interest rates are at record lows, he can invest in Treasury bonds at about 3 percent. $4,800 invested at 3 percent annually will net him $2,160 over a 15-year period. Since this is money that can’t be earned if it is used to pay closing costs, it also must be subtracted from the savings. Now our savings gap is reduced to $4,380.
  • Finally, there’s the issue of the mortgage interest tax deduction. I’m no tax expert, but the last time I checked, mortgage interest is still deductible and closing costs are not. My amortization schedule tells me that the 4.25 percent plan pays $11,331 more in interest than the 4 percent plan. Assuming my borrower continues to have an income to support the mortgage payment, he pays fewer taxes under the 4.25 percent plan.

Assuming a 33 percent tax bracket, the tax savings would amount to $3,739 over the 15-year period. Subtract this from our shrinking savings gap and our overall savings by taking the 4 percent rate is now only $641.

These are all very reasonable assumptions and numbers don’t lie. It says that if a borrower indeed holds the loan for the full term, he saves only $641. But if he pays off the loan anytime earlier than about 14 years, he made the wrong decision.

Henry Savage is president of PMC Mortgage in Alexandria, Va. Send e-mail to henrysavage@pmcmortgage.com.

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