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No-cost mortgages carry a pricetag

Recently, homeowners with considerable equity in their home refinanced in order to take out enough cash to buy a new car. The refinance transaction didn't cost them a dime. All the customary fees like title insurance for the lender and the appraisal fee where paid for by the mortgage broker.

No-cost, no-fee mortgages are readily available. They are particularly popular with people who are refinancing. Here's how they work. The borrowers pay no upfront costs to obtain the mortgage. The lender gives the mortgage broker a rebate at closing. The broker uses the rebate to pay the borrower's normal closing costs. The rebate also covers the broker's own fee for originating the loan.

Even though you can avoid paying upfront fees, no-cost mortgages do carry a price tag. The trade off for no fees is a higher interest rate on the mortgage. For example, the borrower above obtained a $230,000, 30-year fixed-rate mortgage with a 6 percent interest rate and paid no upfront fees. If the borrowers had paid one point and customary closing costs, the mortgage interest rate would have been 5.65 percent.

"Points" is a term used in the mortgage industry for the mortgage origination fee. One point is equal to one percent of the mortgage amount. On a $230,000 mortgage, a one point fee costs the borrower $2,300.

There is an inverse relationship between the number of points charged by the lender and the interest rate on the mortgage. The more points paid upfront, the lower the interest rate and vice versa. Generally, one point is equivalent to 1/4 percent in interest rate.

HOUSE HUNTING TIP: Several factors come into play when you decide whether or not it makes sense for you to pay points. The most important is how long you plan to keep the mortgage before you either sell the property or refinance again. The longer you plan to keep the mortgage, the more sense it makes to pay points.

Keep in mind that the IRS treats points paid by buyers who are purchasing a home differently from points paid by homeowners who are refinancing. When calculating income tax liability, home buyers can deduct points in the year they are paid. However, refinance points must be written off over the term of the loan-over 30 years for a 30-year loan, for instance. If, however, a refinanced mortgage is paid off early, any unclaimed points can be deducted at that time.

The best way to figure whether or not it makes sense for you to pay points is to complete a simple cost benefit analysis. Suppose you're considering two mortgage options. One is a $230,000 no-cost mortgage at 6 percent with a monthly payment of approximately $1379. The other is a one and one-half point mortgage at 5.5 percent with a $1306 monthly payment-a savings of $73 per month, or $876 a year.

Now look at the amount of cash you would pay upfront if you took the full cost mortgage option. Points will run $3,450 (multiply $230,000 loan amount by 1 1/2 percent). Add an additional $2,000 in fees (for customary closing costs) for a total of $5450. The closing cost fee will vary depending on individual circumstances.

Next, divide $5450 by the amount you'd save per year if you took the lower interest rate loan -- $876 in this example. The result (6.22) is the number of years you would need to keep the loan in order to break-even when compared with the no-fee option. 

Homeowners who plan to be in their home indefinitely are usually better off paying points for a lower interest rate.