"Now you can lower your monthly payment at no cost to you." Sound familiar? Many people took advantage of the historic downtrend in interest rates during the 1990s. Reducing your monthly payment can be, and often is a good idea. If you invest the monthly savings, you'll be doing everything possible to maximize the benefits of refinancing. In the 90s, many people refinanced numerous times with zero-point/fee loans--and why not? When you can lower your mortgage payment for "free", shouldn't you always do so? As you'll see, simply because you can refinance with a zero-point/fee loan, doesn't mean you should.

The mechanics

Rebate pricing (yield spread pricing, service-release premium) makes zero-point/fee loans possible. Simply put, you pay a higher-than-market interest rate in exchange for cash. The cash is used to pay your closing costs. Here is a hypothetical example of rate/points combinations. The negative points are rebates. One point is 1 percent of the loan amount.

7.25%,   2 points
7.75%,   1 point
8.00%,   0 points
8.50%,  -1 point
9.00%, -2 points

On a $100,000 loan, you can pay 9 percent interest and receive two points, ($2,000) which you can use to pay your closing costs.

What are the benefits of a zero-point/fee loan?

You can lower your monthly payment with no out-of-pocket expenses. In the short-run, you can save money. There may be some recurring costs collected from you at closing, but you'd pay these costs if you didn't refinance. They are not a cost of the transaction. Recurring costs include property taxes, insurance and pre-paid mortgage interest.

What are the disadvantages of a zero-point/fee loan?

The obvious disadvantage is that you're paying a higher rate in order go obtain the rebate. If you pay closing costs from your personal funds, you receive a lower interest rate. If you keep the loan long enough, (approximately two to three years) you'll pay more than if you had paid points, closing costs and received a lower rate. 

Not quite as obvious is something that can happen each time you refinance: you extend the time you have a mortgage. Suppose you purchase a home and obtain a $100,000, 9 percent, 30-year, fixed-rate loan. After three years your loan balance is $97,750. You get a new, $97,750, 8.5 percent, 30-year, zero-cost/fee loan. After another three years your loan balance is $95,330. You obtain a new, $95,330, 8 percent, 30-year, zero-cost/fee loan. You keep the 8 percent loan and pay it off over 30 years. This scenario may seem unlikely, but many people refinanced this way more than once in the 90s. In this situation, refinancing cost more than holding the original, 30-year, 9 percent mortgage. This scenario will cost more because you twice exchanged a 27-year mortgage for a 30-year mortgage. Your home will be mortgaged for thirty-six years instead of thirty.

Zero-point/fee loans can be advantageous. Make sure the rebate covers your closing costs. Don't increase your new loan amount by adding your closing costs to it. For example if your old loan amount was $100,00, your new loan amount should be $100,000. Zero-point/fee loans are especially attractive when rates are declining and you plan to sell your home in fewer than two to three years.