- The Washington Times - Wednesday, May 2, 2007

Last week I answered a reader’s question regarding the so-called “no-cost” refinancing program.

The reader questioned the validity of the term because in the real world nothing comes free.

As an enthusiastic proponent of this program for the last 15 years, I explained that the interest rate on a zero-cost refinancing loan should be about 1/4 percent higher than the same program that would charge standard closing costs. These include items such as attorney settlement fees, appraisal fees, title insurance and county recording fees.

The question of whether it makes sense to pay a slightly higher rate in order to forgo nonrefundable fees is a simple matter of number crunching. In my experience, zero-cost refinancing is the better way to go than taking a lower rate that carries thousands in sunken costs.

To illustrate: A borrower has a $300,000 loan and has a choice to take a 30-year fixed rate of 61/4 percent with no points or closing costs or a 6 percent interest rate that carries the typical closing costs.

In Virginia, these typical closing costs will total about $3,500, assuming no points or origination fees. Our borrower now must answer a simple question: Is it better to pay the $3,500 and take the lower interest rate or take the zero-cost program at 61/4 percent?

To answer this question, we simply need to calculate the payback period. At what point in time will our borrower recoup the $3,500 in closing costs in the form of a lower interest rate and payment?

The principal and interest (P&I;) payment on a $300,000 loan at 61/4 percent is $1,847 per month.

Assuming our borrower prefers to roll the closing costs into the loan to avoid an out-of-pocket expense of $3,500, he would have to increase his mortgage debt to $303,500 for the 6 percent rate. The P&I; on $303,500 at 6 percent is $1,820 — a difference of $27 per month.

Now the question becomes this: Is it worth raising your mortgage debt by $3,500 in order to save $27 per month?

First, let’s look at the tax issues. In the first year of the loan, the 61/4 percent loan would have charged about $550 more in additional interest than the 6 percent loan. Assuming a 25 percent tax bracket, taking the higher rate would result in a tax bill that’s about $136 less. Divide this sum by 12 months, and it results in a monthly tax savings of about $11. This must be subtracted from the $27 difference in payment between the two loans in order to get the true after-tax difference in payment.

The question now becomes this: Is it worth raising your mortgage debt by $3,500 in order to save $16 per month? Simply divide the $3,500 in cost by $16 savings and we discover that it will take almost 219 months, or more than 18 years, before the benefits of the low rate kick in.

There’s one more question to consider. Since the lower interest rate will curtail principal a little bit faster, at what point does the mortgage balance of the 6 percent program eventually drop to a lower level than the 61/4 percent zero-cost program?

Running a simple amortization schedule tells me that the 6 percent loan balance will fall below the balance of the 61/4 percent loan in the 195th month. That’s in the 16th year of the loan.

Numbers don’t lie. If you are 100 percent certain you will hold a loan for more than 16 years, you may want to consider buying down your interest rate and paying points and closing costs. In a practical world, you are far better off taking a higher rate, zero-cost loan.

Henry Savage is president of PMC Mortgage in Alexandria. Reach him by e-mail ([email protected] pmcmortgage.com).

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