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.