A no-cost mortgage surely sounds like a good idea, especially if you're refinancing and worried about high fees and big expenses. And really and truly there are refinancing options routinely called "no cost, "no fee," "no closing cost" and "zero cost" but they all share one characteristic: they're not free.
"No Cost" Does not Equal "Free"
This gets us to an interesting question: If a "no cost" mortgage has a cost then why would you want one? The answer is that while "no cost" mortgages are not free, they can save borrowers big money at closing. Here's how:
Imagine you want to refinance today, and that with your credit you can get a loan at 4.25 percent with a one percent origination fee and normal loan costs (appraisal, title charges, etc.). This kind of pricing is called "par" in the mortgage industry. To get a lower rate, you'd pay extra fees called "discount points." This is called "buying down" your rate. Each point equals one percent of the loan amount. Often, origination fees are expressed in points as well.
The par loan, then, might cost one point for the origination fee ($1,000 for a $100,000 loan) and an additional $1,500 for title insurance, an appraisal, and escrow fees (totaling $2,500). To buy down your rate to 4.00 percent, it might cost an additional discount point, or $1,000. Your total costs in that case are $3,500. That's a pretty large chunk for many people.
The No-Cost Mortgage and Rebate Pricing
The example above illustrates what happens when you buy a rate down, but what about the reverse?
Suppose you don't want to come to the closing table with any cash? What if, instead of a 4.25 percent loan at par, costing $2,500, you could get a loan with no points or fees at a 4.75 percent interest rate?
This is where the cash-to-close with a "no cost" mortgage is found. The costs of closing are offset by a higher interest rate. Raise the rate enough and the lender will pay some or all costs. So a "no cost" mortgage is really a loan with a higher rate, which allows the lender to pay some or all closing costs.
Are no-cost mortgages with higher rates attractive? Depends on your needs and preferences and especially the length of time you plan to hold the property. Check out this chart, which shows all three loan options -- the "par" loan, the no-cost mortgage" and the "bought down" loan. By dividing the difference in costs by the difference in payment, you can see how long you need to have the loan before the monthly savings offset the upfront refinancing costs.
No Cost Refinances: Limited Cash Out
There's another way to get a refinance without out-of-pocket costs. This may also be called a "no-cost" refinance, but there are costs. Instead of raising the interest rate to cover the loan fees, the lender simply adds the costs to the loan amount. This is called a "limited cash out" refinance -- the new loan is larger than the old one, but the borrower doesn't take cash out of the transaction.Taking three loan options again, this chart shows what happens when the costs are wrapped into a refinance (this can't be done with a purchase, only a refinance). Wrapping the costs into the refinance allows the borrower to get a lower rate and payment. However, there are still costs involved.
No-Cost Mortgage Questions
In looking at no-cost mortgage refinancing there are some important questions to consider.
- First, what is the par price of the loan you want, the rate without any points?
- Second, how much of the costs are covered by the higher rate? For instance, will they pay such typical closing costs as transfer taxes, title insurance, escrows for property insurance and property taxes, etc. or just the lender charges? Request a Good Faith Estimate, a written list of closing costs.
- Third, when lenders say they offer a "no cost" refinance, exactly what do they mean?
If you are refinancing with your current lender, ask if money in your present escrow account be used as a credit for the escrow account required with the new loan. If you can shift funds you really might be able to have a closing which requires no dollars from your savings account.
Points paid at closing may be treated differently, tax-wise, than points paid with a higher mortgage rate. That may affect which loan is the better choice. Check with a tax professional and see IRS Publication 936, Home Mortgage Interest Deduction.
Does refinancing make sense? Try running the numbers using LendingTree's Refinance Breakeven calculator.
Finally, shop around. Different lenders offer varying combinations of rates, discounts and credits. LoanExplorer from LendingTree lets you indicate the number of points you're willing to pay, and by clicking the "+ Points" link, you can specify that you only want to see offers with no fees or points.