July 19, 2004, Revised November 28, 2006, July 5, 2007, January 5,
2008, June 19, 2008
No-cost mortgages don’t eliminate costs, they convert them from costs
paid upfront to costs paid over time. Other things the same, no-cost
mortgages carry higher interest rates, which may be better for some
borrowers, but not for others. At the same time, no-cost mortgages are
easier to shop because of their simplicity, so the borrower may get a
better deal.
What Are No-Cost Mortgages?
A no-cost mortgage is one on which the lender pays the borrower’s
settlement costs, with the following exceptions:
* Per diem interest, which is interest from the closing date to the
first day of the following month, isn’t included
because it is not known until the exact closing date is set.
* Escrows for taxes and insurance, which are borrower funds set aside to
assure payment of the borrower’s future obligations, are not covered
because they are not a cost of the transaction.
* Homeowners’ insurance is not covered because, while required by the
lender, it also benefits the borrower. Owner’s title insurance is not
covered because it is optional or paid by the seller.
* Transfer taxes, if any, are not covered because the amount is
sometimes uncertain, and it is set by a governmental entity.
All other costs, including the mortgage broker’s fee if there is one,
are paid by the lender.
Don’t Confuse No-Cost With No-Cash
This is one of the worst mistakes a borrower can make. "No-cash" means
the borrower does not have to pay the settlement costs at closing, but
the lender doesn’t pay them either. The costs are added to the loan
balance, so the borrower pays them over time, with interest.
Borrowers Pay A Higher Interest Rate On A No-Cost Mortgage
The lender finds that rate by estimating the costs for which he would be
responsible, and then finding the interest rate that justifies paying
those costs.
For example, Doe is borrowing $200,000 on a 30-year fixed-rate loan. The
lender’s price schedule on this loan includes the following quotes:
6.25% with zero points, 6% with 1.5 points, and 6.75% with a 2.125-point
rebate. Points are upfront payments - one point is 1% of the loan
amount. Borrowers pay points to the lender but lenders credit borrowers
for rebates.
Assume Doe wants a no-cost loan. The lender calculates that it would
cost $4,000 to assume responsibility for the settlement costs Doe would
otherwise pay. He thus charges Doe 6.75% for a no-cost loan. The rebate
of 2.125 points at 6.75% is $4250 on a $200,000 loan, or enough to cover
the $4,000.
No-Cost Loans Are Least Profitable To Borrowers With Long Time Horizons
The benefit of the no-cost loan is the saving in cash outlay at the
outset, while the cost is the higher rate. The longer the borrower has
the mortgage, the higher the cost. A borrower with a long time horizon
who takes a no-cost mortgage only to save cash gets a bad deal.
A Long Horizon Is One That Exceeds The Break-Even Period (BEP)
The BEP is the period during which the cost of the higher rate just
equals the benefit of having lower upfront costs. Over periods shorter
than the BEP, the no-cost loan has lower costs. Beyond the BEP, the
no-cost loan has higher costs. No-cost loans are more advantageous the
longer the BEP.
I have two BEP calculators, 11a for fixed-rate loans and 11b for ARMs.
The calculators factor in the tax benefits on interest and on points,
the reduction in loan balance, and interest loss on monies used to make
monthly payments and pay points that could have been invested.
11a
Break-Even Period on FRMs
11b
Break-Even Period on ARMs
The BEP for Doe in selecting 6.75% with a 2.125 point rebate rather than
6.25% at zero points is somewhere between 4.5 and 8 years. The exact BEP
depends on Doe’s tax bracket, and on the return he could earn on
investments.
The BEP is longer if the lender marks up the costs charged borrowers who
pay the costs but not the costs used in setting the no-cost rate. The
lender in the example assumed that he would have to pay $4,000 in costs
on the 6.75% no-cost loan. The calculated BEP assumes that Doe would pay
$4,000 in settlement costs on the 6.25% loan. However, if the lender
would charge Doe $6,000 when Doe pays his own settlement costs, the BEP
rises to 6-11 years. In effect, the no-cost loan allows Doe to avoid
being overcharged.
In fact, retail lenders dealing directly with borrowers do sometimes
charge fees above the cost of providing services -- when they can.
Wholesale lenders don’t because their fees are scrutinized by brokers.
No-Cost Mortgages Help Protect Against Being Overcharged
In selecting a loan provider, borrowers typically shop for rate and
points, ignoring other settlement costs. They usually find out about
these costs after they submit an application, and then they receive
"estimates" that are subject to change. This provides lenders with ample
opportunities to pad their own fees and mark up those of third parties.
When responding to a borrower inquiring about a no-cost loan, however,
lenders do not have that luxury. A borrower shopping for a no-cost loan
has only one price to consider -- the interest rate -- and lenders have
to assume that they are being rate shopped. The rates they quote,
therefore, are likely to cover their true costs, which could be well
below the costs faced by borrowers who don’t go the no-cost route.
No-Cost Loans Can Also Limit Broker Fees
On no-cost loans that go through brokers, the broker’s fee is an
additional cost that must be covered by the rate. This can limit broker
fees because lenders cap the rebates they are prepared to offer for
higher interest rates.
A recent study of brokered loans by Susan Woodward showed that total
settlement costs including broker fees were $1500 lower on no-cost than
on other loans. While no breakdowns were available, it is likely that
most if not all of the $1500 was lower broker fees.
A No-Cost Shopping Strategy For Refinancing Borrowers
On a refinance, no-cost loans are widely available because most lenders
are prepared to assume full responsibility for settlement costs. Most of
the settlement costs on a refinance are lender fees, and the third party
services that generate charges (such as appraisal or credit) are often
waived. Guaranteeing settlement costs involves little risk to the
lender.
Borrowers can shop for the lowest no-cost rate, and can shop brokers and
lenders interchangeably. They need not concern themselves with brokers’
fees because the fees are covered by the rate.
A Modified Strategy For Refinancing Borrowers With Long Time Horizons
Refinancing borrowers with long time horizons can shop for a no-cost
mortgage, yet buy down the rate by paying points. Decide the rate you
want to pay, then shop for the lowest total lender fees (points and all
other lender fees) on a loan that is otherwise no-cost, meaning that the
lender pays all third party fees.
I suggest you find your shopping rate on one of the
Upfront
Mortgage Lenders by taking the lowest rate shown for the mortgage
you want. If the rate selected is 6% on a 30-year FRM, you can ask other
loan providers "What are your total lender fees for a 6% no-cost 30-year
mortgage?" Be prepared for some funny stares, to be told that it can’t
be no-cost if you are paying lender fees, but don’t be deterred,
Warning: Do not shop for the lowest no-cost quote, select the loan
provider, and then buy down the rate by paying points. The negotiation
could cost you everything you gained in the shopping process.
No-Cost Loans On A Home Purchase
Home purchases involve a number of third party charges that lenders may
have difficulty in pricing. At this writing, the only lender who will
guarantee settlement costs on a home purchase is Bank of America, see
No Fee Mortgage Plus. You can start there and compare their quotes
with those of UMLs, recognizing that the UMLs are estimating rather than
guaranteeing the third party costs.
Not Quite No-Cost
You can shop for a not-quite no-cost loan at any of the Upfront Mortgage
Lenders, see
List of
Upfront Mortgage Lenders. These lenders guarantee their own fees,
but not third party fees, which are estimates but honest estimates. If
the estimate turns out too low, you will be liable for some fees you
thought were covered. If the estimate turns out too high, your costs
will turn out to be lower than you expected. As far as I can tell, your
chances of coming out ahead are 50-50 or better.
This isn’t as good as having third party fees guaranteed, but it isn’t
that bad either. Since these lenders show their detailed estimates of
third party charges, you can get an idea of how large an error might be
by comparing their estimates.
Don't Look at the APR on a No-Cost Mortgage
The APR is often over-stated on a no-cost loan because the third party
settlement costs paid by the lender's rebate are not included in the APR
calculation. See
Annual Percentage Rate Below Interest Rate on FRMs. Just ignore the
APR.