If you can, pay closing costs when you close

Question: When you refinance, should you pay your closing costs upfront, or roll them into the loan amount? Are there any tax differences? Also, I’ve heard that a home-equity loan allows you to avoid many of the fees you have to pay with conventional financing. Would an equity loan be a better way to refinance?

H.B., Snohomish

Answer: Refinancing is relatively expensive. Closing costs typically total approximately $2,700, and if you want to pay points, a percentage of the loan amount, to get a lower interest rate, the costs are even higher.

Most borrowers add those costs to their loan amount for the simple reason that they don’t have thousands of dollars sitting in the bank to pay the costs out of pocket.

However, if you have cash to spare, it may be a good idea to pay your closing costs at the close of escrow, rather than adding them to your loan amount. If you add the closing costs to your loan amount, you end up paying more in long run because you are paying interest on your closing costs in addition to the original loan balance.

For example, let’s say you want to refinance your 6.5 percent $250,000 30-year fixed-rate loan with a 5.5 percent 30-year fixed loan. Let’s further assume that the payment on the existing loan is $1,580 per month. By reducing your interest rate to 5.5 percent, your payments on the new $250,000 loan drop to $1,420 per month (I’m rounding off the numbers to make it easier to follow), which would be a savings of $160 per month.

To get that rate, you would have to pay $2,700 in closing costs plus two points (2 percent of your loan amount) of $5,000, for a total of $7,700, you would recoup those costs in just over 48 months from the savings ($7,700/$160).

Now, if instead of paying those closing costs in cash you added the $7,700 to your loan amount, the monthly payments on a $257,700 loan would be $1,463. That means you would save only $117 per month, extending your break-even point to almost 66 months ($7,700/$117).

But that’s not the only consideration. After you pass the break-even point, you would continue to pay $43 per month more with the larger loan amount than you would have paid with the smaller loan amount ($1,463 vs. $1,420). Over the remaining life of the loan, that totals $12,642.

Of course, if you don’t have an extra $7,700 lying around, this is merely an academic argument. And the reality is that very few people actually hold a 30-year fixed-rate mortgage for the full-30 year term. Most people pay it off within about seven years or less, by either refinancing or selling their home.

For tax purposes, there is no difference between paying closing costs in cash or adding them to the loan. The only tax-deductible portion of these costs are the loan fees, or points.

In the example above, the points totaled $5,000. This fee would have to be amortized over the life of the loan. The $5,000 divided by 30 years is only $166.66 per year. If you’re in the 28 percent tax bracket, that saves you a whopping $46.66 in income tax. Hardly worth worrying about. The main purpose of refinancing is to save you money each month, not reduce your tax bill.

As for your question about home-equity loans, you are correct, they are much less expensive to obtain than a new first mortgage. Banks often offer these loans with no points and no closing costs. Because of the major interest-rate reductions by the Federal Reserve this year, the interest rate on home-equity loans are very affordable right now. You can find them in the 5 percent range.

But you better hurry. Many banks and mortgage lenders are closing down their second mortgage programs because falling home values across the country have made those loans too risky.

Mail questions to Steve Tytler, The Herald, P.O. Box, Everett, WA 98206, or e-mail him at economy@heraldnet.com.