Q: When you refinance, should you pay your closing costs up front 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
A: Refinancing is relatively expensive. Closing costs typically total approximately $2,000. If you want to pay points 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, you pay 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 $175,000, 30-year, 8 percent fixed-rate loan with a 6.375 percent 30-year loan. Let’s further assume that the payment on the current loan is $1,350 per month. By reducing your interest rate to 6.375 percent, your payments drop to only $1,091.77 per month – a savings of $258.23 per month.
To get that rate, you would have to pay $2,000 in closing costs plus two points (2 percent of loan amount) or $3,500, for a total of $5,500. You would recoup those costs in 21.29 months due to the monthly savings. Now, if instead of paying those closing costs in cash you added the $5,500 to your loan amount, the monthly payments on a $180,500 loan would be $1,126.08. That means you would save only $223.92 per month compared to your current payments, extending your “break-even” point to 24.56 months.
But that’s not the only consideration. After you pass the break-even point, you would continue to pay $34.31 per month more with the larger loan amount than you would have paid with the smaller loan. Over the remaining life of the loan, that totals $11,508.95. That’s the interest penalty you pay for borrowing your closing costs rather than paying them in cash at closing.
Of course, if you don’t have an extra $5,500 lying around, this is merely an academic argument.
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 $3,500. This fee would have to be amortized over the 30-year life of the loan, providing someone in the 28 percent tax bracket with an income tax savings of a whopping $32.66 a year. That’s 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 6 percent to 7 percent range, with loan terms of 15 years, and in some cases, as long as 30 years. If you are looking for a cash-out refinance rather than looking for a loan to lower the payment on your primary mortgage, a home equity line is a great way to go. You can get a low interest rate for a no-cost loan if you shop around. Major banks and savings and loans are the best sources of home equity loans.
Mail your real estate questions to Steve Tytler, The Herald, P.O. Box 930, Everett, WA 98206. Fax questions to Tytler at 425-339-3435, or e-mail him at economy@heraldnet.com
Steve Tytler is a licensed real estate broker and owner of Best Mortgage, Inc. You can visit the Best Mortage Web site at www.bestmortgage.com.
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