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Just Ask Josh: Is it really possible to get a no cost loan? Isn't there no such thing as a free lunch

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Mortgage and Lending with NONE

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!

Comments(19)

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Jeff Belonger
Social Media - Infinity Home Mortgage Company, Inc - Cherry Hill, NJ
The FHA Expert - FHA Loans - FHA mortgages - USDA loans - VA Loans

Josh... good to see you back. EXCELLENT post....  I agree with everything that was said, because this is so misconstrued in the mortgage business.  People have to make money. It's all advertising when not explained the way that you did and the same way that I explain all of the time to my clients. Meaning, the break even point. Very easy and basic math. And also, you can look at the amortization and use this to help you decide on costs and no costs.

One thing that I did want to mention:   just clarifiacation on lenders....mortgage companies, bankers, and brokers...... and the Yield Spread Premium.  Remember this..... ALL companies have YSP... even Counrtrywide and Wells Fargo. It doesn't matter if they sell the loan or service it. If I was a broker selling to Countrwyide, I am getting their discounted price that is not offered to clients. As I have always stated, we all buy the same money from the same place, unless you are a Credit Union or Bank that doesn't use Fannie Mae or freddie securities....  I just wanted to point this out, because these larger companies can't do anything different than I can or Josh....It comes down to profit margin.  Just an FYI. It comes down to service, integrity, honesty, and educating the client as Josh just did in this post.

Jan 15, 2007 06:14 AM
Tim Maitski
Atlanta Communities Real Estate Brokerage - Atlanta, GA
Truth, Excellence and a Good Deal

Josh, Good explanation. 

One also needs to account for the time value of the money you aren't spending on the closing costs. And also the higher interest you'll have as a tax deduction by going with the higher interest rate no cost loan.  Do you by any chance have a good calculator that takes all of this into consideration?

Jan 15, 2007 06:16 AM
Professor X
NONE - Ludington, MI

Jeff did you want to mention something additional or was it the ammortization schedule.

Ammortization schedule is a good call too for the educated consumer.

Jan 15, 2007 06:18 AM
Jeff Belonger
Social Media - Infinity Home Mortgage Company, Inc - Cherry Hill, NJ
The FHA Expert - FHA Loans - FHA mortgages - USDA loans - VA Loans

Josh.... I had a phone call and I didn't want to leave my comment untouched and then send it and now it's number 15th as a comment.... and lost in the shuffle... lol   Again, great post.

And I loved the cartoon...awesome.

Jan 15, 2007 06:20 AM
Professor X
NONE - Ludington, MI

Good Call Tim,

but this is a basic explanation made for your average homeowner, The average difference in taxable interest on most of these transactions is less than 200 or 300 dollars per year...hardly enough in most cases to really do anything major to your itemized deductions.

But for large loan amounts and really really educated consumers, Tim's suggestions are even further reasons to consider.

Jan 15, 2007 06:24 AM
Jeff Belonger
Social Media - Infinity Home Mortgage Company, Inc - Cherry Hill, NJ
The FHA Expert - FHA Loans - FHA mortgages - USDA loans - VA Loans
Tim....I'll jump in if Josh doesn't mind. Calculator?   In my opinion, it comes down to my clients goals and needs, that helps me help them make these decisions.....  and yes, by using a calculator. But you can use this until you know or have a good idea in regards to their goals.
Jan 15, 2007 06:26 AM
Maureen Francis
Coldwell Banker Weir Manuel - Bloomfield Hills, MI
Coldwell Banker Weir Manuel
Of course I will be linking back to this from miOaklandCounty.com.   Is this an AR/Localism exclusing or is it going to be on your domain too?  Just need to know how you want the links.
Jan 15, 2007 06:28 AM
Ken Stampe
iBrandPlan.com - Grow your e-Profile & Brand - Dallas, TX
iBrandPlan

great post josh. There are some free lunches but you have to know the restaurant owner. For example, the bank will do a true no-cost loan to our premier financial services clients because the $500k or more they have invested through the bank is more valuable then one mortgage loan. This is small potatoes but exists in pockets.

Ken Stampe - Bank of America Mortgage

Jan 15, 2007 06:30 AM
Tom Burris
NMLS# 335055 - Baton Rouge, LA
Texas/Louisiana Mortgage Pro - 13 YRS Experience

great post.

too bad most consumers dont get it

 

Jan 15, 2007 06:44 AM
Chris Tesch
RE/MAX Bryan-College Station - College Station, TX
College Station, Texas Real Estate
Excellent post with great information! 
Jan 15, 2007 06:45 AM
Jason Sardi
Auto & Home & Life Insurance throughout North Carolina - Charlotte, NC
Your Agent for Life
Great blog and a good point with what Ken Stampe said in his comment.   Somebody once asked me if there was such a thing as a free loan and I said, "It's called a Grant."
Jan 15, 2007 06:52 AM
Jeff Belonger
Social Media - Infinity Home Mortgage Company, Inc - Cherry Hill, NJ
The FHA Expert - FHA Loans - FHA mortgages - USDA loans - VA Loans
I agree with Ken.... but define no cost. Yes, relationships mean a lot... but there is still a cost and price...  where was it collected, at what point, and for how much...to be able to give that free lunch.  Ah, something that is not mentioned or thought of...  just some food for thought....
Jan 15, 2007 06:54 AM
Scott Gormley
Oak Valley Mortgage-California Home Loans and Refinancing - Chico, CA

Hey Josh,

Good post. I can explain this to clients over and over again, every day of the week. So, I wrote an article about it a while back and I simply email, fax or hand it to them to read...Saves your breath..lol

Scott

Jan 15, 2007 07:01 AM
Ken Stampe
iBrandPlan.com - Grow your e-Profile & Brand - Dallas, TX
iBrandPlan

um, at the sake of sounding sarcastic....

no cost = $0

If it costs you $2,500 in closing costs at lender A to get a loan at 6.25%, and the bank gives that client a 6.25% mortgage at $0 closing costs then the loan is at no cost to the customer.

It is a measure of relationship value. If a client is investing funds through the bank at normal margins, a $2,500 absorption of closing costs is a very affordable decision to make versus the risk of that client taking their mortgage to say, Citibank and then moving their money to Citibank Smith Barney.

What Jeff is trying to say is that if you don't pay anything for your loan, you are probably paying for it somewhere else. That may be true. It isn't in this case, but it may be in another.

Jan 15, 2007 07:03 AM
Jeff Belonger
Social Media - Infinity Home Mortgage Company, Inc - Cherry Hill, NJ
The FHA Expert - FHA Loans - FHA mortgages - USDA loans - VA Loans

Ken... it's my opinion and I wasn't trying to make you look bad. But in all honesty, how do you know? Unless you see their breakdown, their spreadsheet, sure... you can absorb things like this....  but you have two different cost centers per se. This is a lot more detailed than what is being explained.

Let me throw it out another way. Let's say this client is getting an x, w, z deal with your bank because of the clients investment. And let's say their profit margin is a little higher than many companies out there. Just on this particular type of transaction. Unless you are the CFO and see the books, you still can't safely assume what you said is 100% accurate. That's all I was trying to say. I agree with what you are saying and that it can and does work. Even the originating branch has a certain degree of flexibility to make this happen. It's basically money exhanging hands, to keep it all in house. But again, at what price. Just because you don't see it....the client doesn't see it.....  there could be someone or something that off sets this.  Could.  not meaning that there is....   again, it was only food for thought and that was it.

Jan 15, 2007 07:12 AM
Jennifer Fivelsdal
JFIVE Home Realty LLC | 845-758-6842|162 Deer Run Rd Red Hook NY 12571 - Red Hook, NY
Mid Hudson Valley real estate connection
Great information.   I wonder if you will be getting questions from the consumers from localism.
Jan 15, 2007 07:16 AM
William Collins
ERA Queen City Realty - Scotch Plains, NJ
Property and Asset Management

Joshua,

Thanks for the post. This is invaluable information. I enjoyed the dialogue going on amongst the mortgage gurus. More consumers need your type of guidance on this issue.

Jan 15, 2007 07:32 AM
Professor X
NONE - Ludington, MI

Ken, I am with you on this one....There is such a thing as a true no cost loan, and as I put in this post, even when the rate is slightly higher, it still can make more sense than paying costs with a lower rate.

Maureen....it will be going on www.joshplummer.com so you can link there if you like

Everybody...I have been less active on the AR front than I was at one time, What is Localism?

Jan 15, 2007 11:47 AM
Loren Johnson
White Bear Lake, MN
CMPS

If only more consumers understood that we all (brokers & banks) work out of the same "pie".....it just matters how we want to 'slice' it. Most brokers slice it to get some YSP & some Origination Fee.... but you CAN slice it to a 'no-cost close'....from the consumer's point of view. However, it just means the rate will be larger.

 

Jan 16, 2007 07:24 AM