This weeks question for Just Ask Josh comes to us from Maureen Francis, Birmingham Michigan's leading Realtor and author of the mioaklandcounty blog. We've been hanging onto this question for a while, waiting for a good week to post it.
"Our mortgage bank just sent a letter that they will give us a refi loan
with no fees and no closing costs. Is that really possible, or am I
just paying through a higher interest rate or something? Isn't there "no
such thing as a free lunch?"
Maureen,
This is a very good question, because in this situation, like many others, there are some instances where this makes sense and other instances where it makes no sense at all. To understand how an offer like this works, you must first understand how mortgage originators and brokers are paid. This is an industry trade secret, so if I disappear after sharing this with you, then you should know why.
Mortgage brokers are paid by whatever bank they originate your loan through. In order to encourage mortgage brokers and bankers to originate loans with their institution, banks offer brokers compensation in return for the business. This compensation is known as basis points or Yield Spread Premium. The yield spread premium that a broker earns for originating a loan is usually a certain percentage of your entire loan amount. The higher the rate the more money the broker makes on your loan. Because Yield Spread Premium is a percentage of your total loan amount, it also stands to reason that the larger your loan amount, the more money a broker will make on your loan. (1% of 300,000 is a lot more than 1% of 80,000.)
Whenever a lender or broker offers to "pay your closing costs" or offers a "no closing cost loan" they are simply taking their yield spread premium and using it to cover the costs associated with your loan. While some lenders are willing to make less money on your loan in order to offer you a no-cost loan option, others may offer you a higher interest rate in return for this option. In order to tell if a no-cost loan really makes sense for you, you must know how to compare it to a traditional loan where you pay the closing costs.
Most people refinance their mortgages in order to save money. If you are considering refinancing to save money, you must always remember that there are costs associated with a mortgage. This means if it costs you money in order to save money, you have to compare the cost with the savings in a sort of cost/savings analysis to determine when you will break even and to see if the refinance actually makes sense. While I suggest you see a professional mortgage banker or financial planner to determine an accurate "break even point," you can do a simple calculation yourself to get a basic idea. Simply take the cost and divide it by how much money you are saving per month by refinancing. This will tell you how many months it will take you to "break even." Now all you need to do is compare it to how long you think you will stay in the house and if the break even is less than the amount of time you plan to stay in the house, then the refi makes sense. It is obvious reasoning that if you do a "no cost" loan then the "break even" point is immediate and it usually starts making sense much quicker than a loan that costs money. I usually recommend a no cost loan if at all possible, even if the rate is slightly higher. If you want to be really accurate, you must also compare how much interest you will pay by refinancing if you are resetting your loan back at day one when you may have already paid 2, 5 or 10 years off of your current loan, but for the purposes of this discussion, that is irrelevant.
Usually, (but not always) a no cost loan comes with a slightly higher interest rate than one with a cost. Let's look at an example. Let's say you currently have a $100,000 mortgage at 7% and you pay $665 per month for this loan, but you are considering refinancing it. You can get 6.25% and roll $1500 in closing costs into your loan, or you can get 6.5% and get a no-cost loan. If you take the 6.5%, your new monthly mortgage payment would be $632 per month, but if you take the lower rate 6.25% your payment would be a lower $624 per month. Your savings on the loan is marked by how much less interest you are paying. The difference in the interest between these two loan amounts is about $12 per month. But if you have to pay $1500 in order to save $12 per month, it will take you 125 months or almost 10.5 years before you break even. This "break even" point is drawn out even farther if you have recently refinanced and you paid closing costs last time as well. While over the life of the loan, the $12 per month could amount to a savings of $4,320, if you don't keep the loan for longer than 10.5 years (most people keep a loan an average of 5-7 years) or if you sell the home before your 10.5 year period is up, (think about this if you are in your "starter home" or if you are planning on growing your family, or if your job moves you often.) then it might not always make sense to take the lowest rate.
I usually recommend no-cost loans whenever they are available. Especially in the following situations:
You only plan on keeping the home a short time, or you are unsure how long you will stay in the house.
You have recently refinanced and paid closing costs recently,
You are only lowering your interest rate a very small percentage from your current rate.
You have a pre-payment penalty on your current loan
You owe as much as your house is worth, or very close to it.
While some mortgage companies may give you a higher rate in order to offer you a no cost loan, if you remember to check your break even point and compare it with how long you plan on keeping your home, a no cost loan is often your best option!
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