Beware the “No-Cost” Mortgage Refinance
As a followup to last week’s post about finding the best mortgage rates, I just wanted to remind you that there is no such thing as a free lunch. I mention this because those of you that are in the market for a new mortgage are likely to be confronted by offers for a “no-cost” refinance. While this isn’t necessarily a bad thing, it’s important to know what you’re getting into.
What’s a “no-cost” mortgage refinance?
A “no-cost” refinance is one in which the lender or broker covers the closing costs on your new mortgage. Depending on where you live, you can expect to pay 2-3% of the loan amount when closing a typical mortgage, so this is a great deal. Right? Well…
The reason I keep putting the term “no-cost” in quotes is because there actually is a cost — you just don’t typically see it. In other words, the lender doesn’t eliminate the costs, they simply convert them into another form. In most cases, this means that you’ll wind up paying a higher interest rate.
It works like this… Just as you can buy points to reduce your mortgage rate, you can increase your mortgage rate in return for negative points. Each point is equal to 1% of the loan amount. By accepting a higher than market rate on your loan, you can generate cash back that lender can use to cover the closing costs.
Clearly, this approach is most beneficial to those with a short time horizon, as they’ll enjoy the upfront cost savings without having to live with that higher rate for very long. If you decide that the “no-cost” option is best for you, be sure to get a full rundown of the costs that are covered so you can make a meaningful comparison across lenders — not everyone covers all the same things.
“No-cash” is not the same as “no-cost”
Perhaps the biggest mistake that you can make when shopping for a “no-cost” refinance is to wind up with a “no-cash” deal instead. While the names sound very similar, these are very, very different products. With a “no-cash” refinance, the closing costs are rolled into the balance of the new loan.
Because there aren’t any negative points involved with a “no-cash” refinance, the rate will likely appear more competitive on a “no-cost” refinance. Unfortunately, you’ll wind up paying the fees yourself over time plus interest.
Published on May 27th, 2009 - 13 Comments
Filed under: Debt Reduction, Mortgages, Real Estate
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About the author: Nickel is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!
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Universial truth: There is always a “catch” and a “cost.”
Nice post!
Comment by DDFD at DivorcedDadFrugalDad — May 27th 2009 @ 8:30 amTanstaafl is a great principle to always keep in the back of your mind, but in today’s lending market “no-cost” refinancing may be a great option. I say this because in most cases rates today are likely to be much lower than what some one already has. Now, if we are talking about a “normal” market everything you said is spot on.
Comment by Jared — May 27th 2009 @ 9:58 amA very basic example:
I have a 30 year fixed with 29 years left at 5%, I get offered a “no cost” refi for let’s say 4.75% as a 30 year fixed.
Why wouldn’t I take it?
Comment by ckstevenson — May 27th 2009 @ 10:29 amInterested in any arguments for/against ckstevenson’s comment since I’m almost in that exact situation and I’ve considered a “no cost” loan myself…
Comment by Kerri — May 27th 2009 @ 4:24 pmckstevenson & Kerri: In the example you give, there’s not much downside. Refinancing resets the clock on your mortgage, but if you’re less than a year in, that’s not a big problem. While this may be a good option, however, you have to ask yourself if this is the best option. If you plan to be in your house for the long haul, then you might be better of paying the closing costs yourself and getting an even lower rate.
What really matters here is the breakeven point. If it will take too long to recover your costs with the lower rate, then the no-cost refinance is a great option. Otherwise, you should really think about biting the bullet and paying the costs yourself.
Of course, the other thing to be sure of is that this is a true no-cost refinance, and not a no-cash refinance (some brokers play it fast and loose with the terminology, so be specific when asking questions).
Bottom line: There’s nothing inherently wrong with a no-cost refinance as long as you understand what it’s all about and are sure that it’s the best option given your circumstances.
I would think that these days your credit would have to be absolutly perfect to get a no cost re-fi.
I am hearing brokers are swampped right now with re-fi’s lets hope this doesn’t lead to another housing problem
Comment by Rob — May 27th 2009 @ 5:16 pmIf you’re planning on paying off the mortgage (instead of using any monthly savings for something else) I think the total lifetime cost is more important than the break-even point.
Comment by Rosa — May 27th 2009 @ 5:51 pmRosa has the right idea and the original post mentioned this as well. Look at the total cost over the lifetime of the loan. Many loan offers tout saving money by lowering monthly payments but ignore the overall cost.
In business I often have customers wanting to cut costs. In their mind this means a lower price or longer terms which is actually shifting costs, much like the no cost, nocash examples. Removing costs like home inspections, title searchs etc. is what you are trying to do. Home Equity loans though not lines of credit tend to be lower cost options. For a refi if you have already done title searchs and other things there is no reason to pay for them again.
Comment by Chris — May 29th 2009 @ 12:02 pmFor some fun reading about the “TANSTAAFL” principle, look it up on wikipedia!
Comment by Danielle — Jun 1st 2009 @ 6:04 pm