These days, it seems you can’t turn on the television or radio without hearing ads from mortgage lenders. Many of them promise “NO POINTS! NO COST! NO FEES!” You really have to wonder how they can get away with claims like this. It sounds so appealing—they’re offering to refinance your home for…free?
Are the claims real?
There are regulations to protect unwary consumers from advertisers’ outrageous claims—especially when those advertisers are mortgage lenders. So how can they claim to give you a mortgage with “no cost?” They must be making a profit somewhere; but where? And how?
The matter of closing costs
Let’s be clear on some important concepts surrounding mortgage finance.
The first thing to keep in mind is that all transactions involving real estate have costs involved. There is always an escrow fee, for example. If a mortgage is involved, the lender will require a policy of title insurance to protect their security interest in the property. There will be additional fees for appraisal, notary and recording.
There are also certain overhead costs that the lender has to cover: underwriting and processing, for example. These are all fees and costs that someone will have to cover. These costs are referred to as “non-recurring closing costs.” They are the actual cost of the loan. There are also other costs involved, such as prorated interest, property taxes and insurance, that you would be paying even if you were not getting a new loan. You should not consider these to be part of the cost of your new loan.
Let’s define “no cost”
Before we go on, we should define what “no cost” really means. For some, it may mean “no cash out of pocket.” This is incorrect. If your total closing costs amount to $5,000 and you add those costs to your new loan balance, you won’t pay any money at closing. You have paid those fees and costs out of the equity in your property, because you increased your loan balance to cover them. Doing this is perfectly acceptable and commonplace, but it is not a “no-cost” loan.
When the term is used accurately (and honestly), it means that you do not pay the non-recurring closing costs out of pocket, and you do not add them to your loan balance.
That may sound like a too-good-to-be-true scam, but it’s not. You can get a rebate from the lender sufficient to pay all of your non-recurring closing costs, and voilà! No cost loan.
How the investor fits in
You may already know that almost all mortgages are sold to investors. Fannie Mae and Freddie Mac are investors, for example. The lender sells the loan they just made to you to Fannie or Freddie for a small profit. The cash price the investor pays is determined by the interest rate of the loan.
The higher the rate, the higher the price they pay. Specifically, the investor pays about 1% more for a loan with a rate .25% higher.
Getting a rebate from the lender
This may be confusing, so here is an example. If you can get a $400,000 loan at 3.75% with no points (one point is equal to 1% of the loan amount), you could ask for a 4% rate (.25% higher) and get a rebate of $4,000. We are passing on to you the higher price the investor pays us for the loan. You will receive that rebate in the form of a credit on your closing statement—there are no coupons to mail in!
Isn’t there always a catch?
What’s the catch? There is none—except that you will have a higher interest rate in exchange for the rebate. If you plan to have the loan for a long time (4 years or longer), you’ll save money over the long term by selecting the lower rate and adding the closing costs to your new loan.
If, on the other hand, you plan to sell or refinance within a shorter period of time, a “no-cost” loan could save you some money over the short term. In the case of our $400,000 example, raising the rate by .25% to get a $4,000 rebate will increase your monthly payment by around $57.00 per month—but you’ll be borrowing less money, since the lender rebate will cover the closing costs. Only you can decide which choice is best for you.