The Truth About a No Cost Refinance

"No cost refinance" is a catch-phrase which may be a bit misleading. However, that does not mean it is necessarily a bad deal, if you can see past the hype and examine the underlying numbers.

The Consumer Finance Protection Agency points out that what is referred to as "no cost" refinancing is typically accomplished in one of two ways.

Two Ways to Refinance

One is that any loan closing costs are simply added to the principal amount being borrowed -- that means you'll have no out-of-pocket costs, but your loan amount will be larger. In the mortgage industry, this is also called a "limited cash out" refinance, because the lender is advancing you extra money and then using it to cover closing costs.

The other "no-cost" refinance is accomplished by charging a higher interest rate in return for having no upfront fees. In either case, the costs you would normally pay upon initially taking out the refinance mortgage are simply spread out over the life of the loan.

So, there is a cost to this type of refinancing. It would be more accurate to call it a "no out-of-pocket-cost refinance," but no lender's marketing department would ever approve such a clumsy name. However, just because the name might be a little misleading, does that mean you should steer clear of the approach? Not necessarily.

As is often the case with financial products, this product has its benefits and drawbacks, and is a great choice for the right borrower. To see if it's the best loan for you, you'll have to crunch the numbers. This is not hard to do with a mortgage calculator.

Benefits of No Cost Refinancing

If there are actually hidden costs to so-called no cost refinancing, does the approach actually have any merit? It does.

First of all, when deciding whether or not to refinance, a no cost refinance loan is easier to compare with your existing loan than one with upfront costs. After all, on your existing loan, the payments are spread evenly over the remaining term of the mortgage. A no cost loan will spread costs evenly in a similar way, making for more of an apples-to-apples comparison of monthly payments and total cost.

A second benefit is that by spreading the closing costs over the life of the loan, a no cost approach can allow you to refinance even if your immediate funds are limited. Thus, the want of a few hundred dollars today won't prevent you from making a financial move that could save you thousands in the years ahead.

Drawbacks of No Cost Refinancing

Still, if you get suspicious every time someone selling something uses a phrase like "no cost," you won't be surprised to find that there are drawbacks to no cost refinancing.

For one thing, this approach requires you to pay interest on costs that would be interest-free if paid up front -- either in the form of interest on principal added to your loan, or as a higher interest rate. If you have the necessary funds to pay closing costs, you might well prefer to do so and not incur these higher ongoing charges.

The second drawback is that the result of those higher ongoing charges might be that you end up paying more in the long run than if you had simply paid the charges upfront. If your goal in refinancing is to save money over the entire life of the mortgage, this would at least partially defeat the purpose.

Making a Decision

So given the pros and cons, how do you decide whether no cost refinancing is right for you? You can sort out your options by using a loan payment calculator. For example, on LoanExplorer by LendingTree, the best $200,000 loan (at the time of this writing) with zero points and zero fees has a rate of 3.75 percent. Put that into the loan payment calculator, and you get a payment of $926.23. Over 30 years (360 payments), you'll pay $333,443. Another option is to pay $3,390 in fees to get a rate of 3.586 percent. If you add $3,390 in loan costs to the base loan amount, you get a refinance loan amount of $203,390 and a payment of $923.10. In 30 years, the second loan will cost you about $1,100 less.

Consider Your Time Frame

However, by adding costs into the loan, you've increased its balance. If you sold your home in five years, you'd owe $182,702. But if you took the no-cost loan with the higher payment, in five years you'd owe just 180,155. It would cost you $2,547 to save $186 in monthly payments.

In general, if the difference in monthly payments is relatively small, you're probably better off with the less expensive loan.

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