There really is no such thing as a "no-cost" mortgage loan. There are always costs,
such as appraisal fees, escrow fees, title insurance fees, document fees, processing
fees, flood certification fees, recording fees, notary fees, tax service fees, wire
fees, and so on, depending on whether the loan is a purchase or a refinance. The
term "no-cost" actually means that your lender is paying the costs of the loan.
All a "no cost" loan means is that there is no cost to you, the borrower.
Except that you pay a higher interest rate.
Understand How Loans Are Priced
A variation of the no-cost loan is the "no points" loan, or even the "no points,
no lender fees" loan. On these loans you pay all the costs associated with buying
a house or refinancing, but you do not have to pay the lender associated fees or
points. However, since lenders and loan officers do not do anything for free, the
profit has to come from somewhere.
So where does it come from?
First, you have to understand how loans are priced and how mortgage lenders and
loan officers earn income. Each morning mortgage companies create rate sheets for
loan officers. The rates usually change slightly from day to day. In volatile markets
they change several times a day. On the rate sheet, there are many different programs,
including the thirty year fixed rate.
There will be one column which will lists several different interest rates and another
column that lists the "cost" for that particular rate. For example:
Rate Cost(points)
====== =============
6.250% 2.000
6.375% 1.500
6.500% 1.000
6.625% 0.500
6.750% 0.000
6.875% (0.500)
7.000% (1.000)
7.125% (1.500)
7.250% (2.000)
In the above example, 6.75% has a "par" price, which means it has a zero cost. The
lower in rate you go, the higher the cost, or "points." A point is equal to one
percent of the loan amount. The parentheses in the cost column for the higher interest
rates indicates a negative number. For example, (1.500) equals -1.500, which means
instead of having a cost associated with the loan, the lender is willing to pay
out money for those interest rates. This is called "premium" or "rebate" pricing.
-- Zero Cost Loans --
How Mortgage Companies and Loan Officers Make Money
The above rate sheet is not a rate sheet designed for public review. In fact, most
lenders have a policy that the public cannot see their internal rate sheet. This
rate sheet is designed for loan officers and the cost column is the loan officer's
cost, not the cost to the borrower. When the loan officer quotes you an interest
rate, he will add on a certain amount, usually one to one and a half points. Most
companies leave it up to the loan officer's discretion how much to add on to the
base cost. However, they usually require at least a minimum add-on, which is usually
one point.
The loan officer's commission depends on his "split" with the company and can vary.
He receives a portion of the add-on and the rest goes to the company.
If we assume the loan officer is adding on one point, and you were willing to pay
one point for your loan, then your rate would be (according to this rate sheet)
6.75%. You would pay one percentage point and receive an interest rate of six and
three-quarters. If you wanted a lower rate and were willing to pay two points, you
could get six and a half percent. If you wanted a "no points" loan, then your rate
would be seven percent. The loan officer and the mortgage company would split the
one point rebate, listed as (1.000) on the rate sheet.
See how it works?
In addition to the cost noted on the rate sheet above, lenders have certain other
fees they like to collect, too. These can include document fees, processing fees,
underwriting fees, warehouse fees, flood certification fees, wire transfer fees,
tax service fees, and so on. Usually, you will not be charged all of these fees,
it is just that different lenders call them different things. Some of them are legitimate
costs to the lender and some of them are simply fees designed to generate additional
income to the mortgage company. They are customary in today's mortgage market and
can vary from around $600 to $1300. In addition, there will usually be an appraisal
fee and a credit report fee. Appraisals and credit reports are usually contracted
out to independent companies even though these are considered to be lender fees.
Note that it is common for companies who charge higher fees to have a slightly lower
interest rate and companies that charge lower fees will usually have a slightly
higher interest rate. So if you shop entirely based on fees, you may actually spend
more money in the long run because your interest rate may be higher.
The point is that if you want a "no points - no lender fees" loan, then on our rate
sheet above, you may get an interest rate of 7.125%. That is because the loan officer
has to bump the interest rate even further than on a "no points" loan in order to
cover his own company's fees.
If you want a "no cost" loan, then the loan officer has to bump your interest rate
even further. That is because all of the costs on your purchase or refinance do
not come from the lender. The escrow or settlement company involved in your transaction
will charge a fee which must be paid. The lender will require title insurance and
the title insurance company charges a fee for providing this insurance. If your
new lender requires information from your homeowner's association (if you have one)
then the homeowner's association will most likely charge a fee for providing those
documents. If you are refinancing, your current lender will usually charge at least
two fees: a "demand" fee, and a "reconveyance" fee. The demand fee is charged simply
for providing payoff information. The reconveyance fee is charged because your current
lender prepares a document which releases your property as collateral for their
outstanding loan. This document is called a reconveyance.
These charges will add about another point to how much the loan officer must collect
in premium pricing in order to cover the costs associated with your refinance or
purchase. For a zero cost loan, he will normally need to collect somewhere in the
neighborhood of two and a half points. Because points are a percentage of your loan
amount and most of the costs are fixed, it takes fewer points to provide zero costs
on higher loan amounts. On smaller loan amounts it takes more. One percent of $200,000
is two thousand dollars and one percent of $100,000 is only $1000, so you can see
how it is easier to cover costs on larger loans.
Does it makes sense to do a zero cost loan?
On a $200,000 thirty year fixed rate loan, the difference in monthly mortgage payments
will be about $87, using the example rate sheet on the first page. Over thirty years,
it works out that you will pay more than $30,000 extra for getting a zero cost loan.
So if you intend to remain in the home for a long period of time it just doesn't
make sense.
Suppose you intend to stay for only five years? On a purchase, using the $200,000
example, if you stayed longer than fifty-five months, it would make more sense to
pay your own costs and get the lower interest rate. If you kept the loan for a shorter
time, then it makes more sense to pay zero costs and get a higher interest rate.
Except for one thing.
If you knew you were only going to be staying in the home for five years you would
probably not want a thirty year fixed rate, anyway. You would get a loan which has
a fixed payment for the first five years, then convert to an adjustable or whatever
fixed rates are five years from now. These loans have an interest rate almost a
half percent lower than thirty year fixed rate loans. Since it is practically impossible
to do a zero cost loan on this type of loan, you would have to compare a zero cost
thirty year fixed rate loan to paying points on a loan with a fixed payment for
five years.
The difference in payments would be about $150. The two and a half point rebate
equals $5000. Working out the math, if you stayed in the home longer than thirty-three
months, it would make more sense to pay the points and get the loan with the five
year fixed rate.
Finally, carry the discussion one step further. Suppose you know you are going to
be in the new loan for less than three years? Doesn't it make sense to get a "zero
cost" loan then?
No.
Then you get an adjustable rate loan. As long as the start rate is two percent lower
than the current fixed rate, you cannot lose. The first year you will save a lot
of money. The second year you will probably break even. The third year, you will
probably give up some of the savings from the first year, but not all of them.
"Zero cost" loans just don't make sense for Homebuyers. But they sound really good
in an advertisement.
Exceptions:
- On a FHA Streamline Refinance Without an Appraisal (not a purchase - which is
what the article talks about), it makes sense to do a zero cost loan. This is mostly
because the new loan has to be exactly the same amount as the existing balance of
the current loan.
- If the Homebuyer only has enough money for down payment and none to cover closing
costs, PLUS no arrangement can be made for the seller to pay closing costs, then
zero costs may make sense (however, I would still recommend negotiating terms with
the homeseller - be willing to pay a higher price in exchange for the seller paying
your costs)
