The “no cost” loan myth explained

By Dave Eshleman

 Nobody wants to pay points and fees to get a loan, which is why lenders love to tout “no cost” loans. The problem is they don’t exist. All loans have costs. Appraisers, title companies, and underwriters do not work for free. But you CAN have a lender pay the costs for you if you’re willing to accept a higher rate.

And this option may be better for you, or better for the bank, depending on your circumstances. Here’s why:

Let’s assume you want to refinance your $600,000 loan, and you’re given the following options on a 30-year fixed rate loan:

OPTION 1: 4.25% at 1 point ($2,951.64 per month)

OPTION 2: 4.5% at no points ($3,040.11/mo.)

OPTION 3: 4.625% at no points and no fees ($3,084.84/mo.)

The non-recurring closing costs should be about $3,000, including title insurance, escrow, appraisal, and the bank’s “garbage” fees. And one “point” is $6,000. So how does the lender make $9,000 in fees vanish?

Here’s how:

Lenders will trade “points” for rate. You want a lower rate? Pay them points. You don’t want to pay points? Pay a higher rate. You want them to pay your closing costs, too? Bump the rate up a little higher. You will either pay them in advance or pay over the long term. There is no free lunch.

So if you take them up on their 4.625% no point, no fee offer, How long will it take before that becomes a better deal for the bank and not so good for you? Note that the difference between options 1 and 3 is $133 per month. Option 1’s points and closing costs total $9,000. Using simple math, it takes 67 months (about 5.6 years) to break even.

(I say “simple” math because I’m not calculating tax deductibility, the potential future value of your initial $9,000 if you put it in some other investment, or the fact that the lower rate will reduce your principal balance faster.)

If you think you’ll move out of your home in 5.6 years or less, or refinance again in a few years, take the no point, no fee option. If you think you’ll live in your home longer than that, consider option #1. Over 30 years, it costs about $39,000 less after closing costs are subtracted.

But what if you don’t have an extra $9,000 to spend? Then consider option 1 and ROLL the costs into the new loan amount by borrowing $609,000. The resulting payment ($2,995.91) is still lower than either of the other two options. The only drawback? If you sell your home in the next few years, you’ll have a higher balance to pay off.

And, if you think you’ll move out in 5 years, why are we talking about a 30-year fixed-rate loan? Wouldn’t you be better served by a 5/1 ARM?

Mortgage loans are not one-size-fits-all propositions. You can tweak them to better fit your goals. Be sure to understand all of your options before falling for the “no point, no fee” lure.

Call us for answers. 408-872-8100

 

 

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