- The Washington Times - Thursday, November 18, 2010

The subject of refinancing is everywhere these days. My assistant and I were having lunch at a local restaurant and overheard the folks at the next table discussing the subject. Specifically, we heard one gentleman proclaim that a “zero-cost” refinance is “bunk” because closing costs always exist.

Later that night, I was surfing business sites on the Internet, and I came across an article about refinancing. One fellow was quoted as saying a zero-cost refinance wraps the costs in either the “loan amount or the interest rate.”

That was when I decided to write this column. Rates are low, and qualified homeowners are refinancing in droves. The concept of the zero-cost refinance is simple: A mortgage broker simply uses the so-called “yield spread premium” to pay the closing costs on the borrower’s behalf. The cost to the borrower is simply that the rate offered on the zero-cost program is a bit higher than a rate that carries closing costs.

Don’t overthink this. If a homeowner takes his $300,000 mortgage with a 5.25 percent fixed rate and refinances it to a new loan with a fixed rate at 4.50 percent and pays zero closing costs, it is a true zero-cost loan. His balance didn’t rise because there were no costs to add to the loan amount and he didn’t pay any closing costs out of pocket.

Some folks tend to think of paying fees and points in order to refinance as a necessary part of the transaction. If I tell them they have a choice to take a higher rate, some folks object and accuse me of steering them into a higher interest rate.

There’s no free lunch, folks. The establishment of a homeowner’s personal financial objectives and a little simple math will determine what type of mortgage program is best for any particular borrower. It’s true that over time, closing costs eventually are recouped through the lower interest rate. That recoup period, however, is longer than most folks realize.

Let’s take a look. A $300,000 loan at 4.50 percent will carry a principal and interest (P&I) payment of $1,520. The broker is offering this rate with no points or closing costs. He also offers a rate of 4.125 percent, but the borrower must pay for the transactional fees associated with the refinance, which, in Virginia, for example, will run in the range of $3,700.

Assuming the borrower rolls the cost into the loan amount, his mortgage debt rises to $303,700. At 4.125 percent, the new P&I would drop to $1,472, a difference of $48. Remember that while closing costs are not tax deductible, mortgage interest is, in most cases. Therefore, a homeowner paying 4.50 percent would pay a bit more interest but get a larger tax deduction because of that extra interest. To keep things simple, let’s discount the $48 payment difference by 20 percent to account for the tax difference. The after-tax difference in payment is now about $38.

Does it make sense to raise your mortgage debt by $3,700 in order to reduce your monthly payment by $38? Do the math. Most of my clients would rather take the higher rate and forego the costs.

Consider also that since the beginning balance on the lower-rate option is higher, it will take a while before the balance on the 4.125 percent loan is lower than the 4.50 percent loan. My amortization schedule tells me that would happen at the 122nd payment.

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

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