The "No Cost" Refinance

Guest-blogging today is Alex Nunemaker, a Loan Consultant with Borrow123.com. He can be reached at alex@borrow123.com with any specific questions or comments.

As a loan consultant I hear a lot about no-cost mortgages being done. The name seems to imply that the loan will be done for free – making it pretty hard to beat! However, there is almost never a time when a loan will truly be done at no cost. If you are ever marketed a "no cost" loan, it is imperative that you know exactly how the loan is being structured.

This type of loan really should be called the “no out-of-pocket cost” loan, because it means at closing you would not have to bring funds to cover closing costs. Traditionally, there are two ways to make this happen. The first way is to get rebate points from the lender by accepting a slightly higher rate. However, lenders have dramatically reduced the amount of rebate points they offer for accepting a higher rate so it is becoming more unlikely to find a rate that will give you enough rebate points to cover closing costs and still have a rate that makes refinancing worthwhile.

What is much more frequent with a no-cost mortgage today is to roll closing costs into the principal of the loan. So in reality there is no immediate cost – but you will pay that cost over the amortization of the loan.

For example, let’s say you are looking to take out a loan for $250,000. Offer A is for $250,000 at 5% with $5,000 in closing costs. Offer B is a no-cost loan also at 5%. More than likely, that $5,000 in closing costs is included in the principal so really you are borrowing $255,000 at 5%. Offer A has the advantage of borrowing less initially by paying today and Offer B allows you to keep money in your pocket today, but you owe more over the life of the loan.

This is not to say that wrapping closing costs is a bad idea – in some ways it can really work for you. For instance, Offer A will give you a Principal & Interest payment of $1342.05. Offer B will give you a payment of $1368.90 – a difference of about $27/month. If that $27 does not make a big difference in your monthly budget it may be worthwhile to keep that $5000 in your pocket right now and roll it into the loan.

Another advantage of wrapping in closing costs is that you can wrap in some additional points into the loan to buy down the interest rate. While you may have to borrow a little more, you can lock in a lower interest rate than you otherwise normally could. This could keep your monthly payment at roughly the same amount (possibly lower) and allow you to pay down the principal faster.

Let’s go back to our example. Offer A stays that same at 5% with $5000 in closing costs. However, Offer B could allow you to buy down the rate to 4.375% at a cost of an additional 1.25 points, or $3225 (bringing total closing costs to $8,187 and rounding the loan amount to about $258,200).

Offer A:
Loan Amount $250,000
Interest Rate: 5%
Monthly Payment: $1342.05
Closing Costs: $5000
Principal Amount after 10 years: $202,860.42
Total Payments after 10 years: $161,046

Offer B:
Loan Amount: $258,200
Interest Rate: 4.375%
Closing Costs: $0
Monthly Payment: $1289.15
Principal Amount after 10 years: $205,422.67
Total Payments after 10 years: $154,698.00

The important thing to take away from this is that Offer A will have a slightly lower balance after 10 years (about $2500). However, Offer B got to where it’s at with $6348 less in total payments ($52.90/month) and without paying $5000 at its inception.

In conclusion, it’s important to realize that there is never really a "no-cost" loan. However you can minimize out of pocket expenses. It is also important to keep in mind your overall goals when making any decision in relation to your mortgage – in order to see the benefits of these rate reductions you need to hold on to the asset (your house) for long enough to see the benefit.