January 29, 2001,
Revised November 1, 2002, August 17, 2004
"I see
advertisements for "no-cost" refinancing that sound too good to
be true. Is it possible to reduce my rate without it costing me
anything?"
There are no-cost
loans out there but you will pay a significantly higher rate than if you
pay the costs yourself. If your existing mortgage rate is higher than the
current rate on a no-cost mortgage, then "yes", you can reduce
your rate without it costing you anything. But that doesn't mean you
should.
It all depends on your time
horizon. If you expect to be out of your house within 2 or 3 years, or you
are not sure and want to hedge, the no-cost loan can be a good deal. If
your time horizon is longer, the no-cost loan should be avoided. There is
no reason to choose a no-cost loan because you are strapped for cash,
since it is usually possible to include the costs of refinancing in the
new loan.
If you shop for a no-cost
loan, make sure that you and the lender agree on exactly what it means. It
is not "zero points" which leaves you responsible for other
types of lender fees as well as other payments to third parties. It is not
"zero fees" which still leaves you responsible for payments to
third parties. And it is not "no cash" because that could mean
that you are paying the costs but the lender is increasing the loan by
enough to cover them. On a true "no-cost" loan, the lender
collects no fees and pays all other settlement costs on your behalf
without increasing the loan amount.
There are some payments borrowers should expect to make on a true no-cost loan. One
is per diem interest, which is interest from the day of closing to the
first day of the following month. On a refinance, you will also pay
interest from the first of the month to the closing day. Another outlay you should expect to pay is escrows, though on a refinance you will
get credit for escrows held by the old lender. In addition, expect to pay
homeowners insurance and any transfer taxes.
I am frequently asked whether
you can tell if you have a no-cost loan from the APR? The answer is,
"yes and no". If the APR is greater than the interest rate
it means that you are paying some lender fees and don't have a
no-cost loan. However, the fact that the APR equals the interest
rate doesn't necessarily mean that you have a
no-cost loan because not all settlement costs are included in the
APR. You are not paying any of the fees that are included in the
APR, but you might still be paying some other settlement costs.
On February 2, 1998 I shopped
for a no-cost 30-year fixed rate loan in an area where settlement costs
(other than fees to lenders) were 2.75% of the loan amount. The best rate
I could find was 8.625%. This means that a no-cost loan would make no
sense for me unless my old loan had a rate above 8.625%. On the same day I
could have had the same loan at a rate of 7.125% and zero points, where I
would be responsible for the settlement costs. Which is the better choice?
My way of answering the
question is to view the costs that I must pay on the 7.125% loan as an
investment, with the return consisting of the saving in the monthly
mortgage payment plus the faster repayment of the loan balance. I
calculated that if the loan remains in force for only 12 months, my return
would be n
egative and the no-cost loan would be the best choice. If the loan runs
for 24 months the return on my investment would be 7.7%, which is a so-so
return that would leave me on the cusp. If the loan runs for 36 months,
however, the return would be 31%, which is a clear winner. These numbers
should be typical of those you would find if you shopped the market
yourself.
The
upshot is that no-cost loans are a good option if you expect to move
within 2 years, and a poor option if you expect to remain for 3 years or
more. The
longer you expect to be in the house, the more attractive it becomes to
get the lower interest rate
by paying the settlement costs.
A no-cost loan might also be
a useful stopgap in situations where you think you might move
shortly but aren�t sure. You can save some money while waiting for the
situation to clarify, and if it turns out that you are going to stay put
after all, you can refinance again later.
Postscript: Readers would do well to look at
No-Cost Mortgages, which discusses
a potential benefit of no-cost mortgages that was not considered above.
Copyright Jack Guttentag 2004
Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.
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