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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

Copyright Jack Guttentag 2008