Paying more upfront is better

Published 9:00 pm Saturday, February 5, 2005

Q 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.F., Snohomish

ARefinancing can be relatively expensive. Closing costs typically total approximately $2,000 or more, and if you want to pay more down 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.

However, if you have cash to spare, it’s 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 the loan, you end up paying interest on your closing costs in addition to the original loan balance.

For example, let’s say you want to refinance your 7 percent, $175,000, 30-year fixed rate loan with a 5.375 percent 30-year fixed loan. Let’s further assume that your payment now is $1,198 a month. By reducing your interest rate to 5.375 percent, your payments drop to $979.94 a month – a savings of $218.06. To get that rate, you would have to pay $2,000 in closing costs plus two points, meaning 2 percent of your loan amount. The points would cost $3,500, making the total cost $5,500. Now, you could opt for a slightly higher interest rate and avoid paying any points at all, but I am using what’s called an interest rate buy-down as a worst case example of how paying closing costs up front compares to adding them to your loan amount.

By saving $218.06 a month, you would recoup the total costs of the loan in a little over two years ($5,500/$218.06). Now, if instead of paying those closing costs in cash, you add the $5,500 to your loan amount, the monthly payments on a $180,500 loan at 5.375 percent interest would be $1,010.74. That means you would save only $187.26 a month compared to your current payments, extending your break-even point from 25 months to a little over 29 ($5,500/$187.26).

That’s not the only consideration. After you pass the break-even point, you would continue to pay $30.80 a month more with the larger loan amount than you would have paid with the smaller loan amount ($1010.74 vs. $979.94 a month).

Over the remaining life of the loan, that totals $10,183.40. That’s the interest penalty you pay for borrowing your closing costs rather than paying them in cash at closing. This analysis assumes that you hold the loan for the full 30-year term, which is often not the case. The sooner you pay off the mortgage, the less interest expense you will have to pay on the financed loan costs. Of course, if you don’t have an extra $5,500 lying around, you have no choice other than adding the costs to your loan amount – or choosing a higher interest rate with lower loan costs.

For tax purposes, there is no difference between paying closing costs in cash or adding them to the loan amount. The only tax-deductible portion of these costs are the loan fees (points). In the example above, the points totaled $3,500. This fee would have to be amortized over the life of the loan. If you divide the $3,500 by 30, the cost is $116.66 a year. If you’re in the 27 percent income tax bracket, that saves you $31.50 in income tax each year – hardly worth worrying about. The main purpose of refinancing is to save you money each month, not reduce your income 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 today’s historically low interest rates, home equity loans are very affordable right now.

You can find them in the 4 percent to 5 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 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 &loans are the best sources of home equity loans.

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Update: Last week I wrote about a Department of Veterans Affairs loan program, and said the maximum loan amount was $240,000. Now, I have some great news for veterans. The VA has just raised the loan limit in high-cost housing areas such as Snohomish and King counties. Veterans in either county can now get a zero-down loan for up to $359,650.

Mail 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.