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The No-Cost Thirty
Year Fixed Rate Mortgage
There really is no such thing as a
"no-cost" mortgage loan. There are always costs, such as appraisal fees,
escrow fees, title insurance fees, document fees, processing fees, flood
certification fees, recording fees, notary fees, tax service fees, wire
fees, and so on, depending on whether the loan is a purchase or a
refinance. The term "no-cost" actually means that your lender is paying
the costs of the loan. All a "no cost" loan means is that there is no cost
to you, the borrower.
Except that you pay a higher interest rate.
Understand How Loans Are Priced
A variation of the
no-cost loan is the "no points" loan, or even the "no points, no lender
fees" loan. On these loans you pay all the costs associated with buying a
house or refinancing, but you do not have to pay the lender associated
fees or points. However, since lenders and loan officers do not do
anything for free, the profit has to come from somewhere.
So where
does it come from?
First, you have to understand how loans are
priced and how mortgage lenders and loan officers earn income. Each
morning mortgage companies create rate sheets for loan officers. The rates
usually change slightly from day to day. In volatile markets they change
several times a day. On the rate sheet, there are many different programs,
including the thirty year fixed rate.
There will be one column
which will lists several different interest rates and another column that
lists the "cost" for that particular rate. For example:
Rate Cost(points)
====== =============
6.250% 2.000
6.375% 1.500
6.500% 1.000
6.625% 0.500
6.750% 0.000
6.875% (0.500)
7.000% (1.000)
7.125% (1.500)
7.250% (2.000)
In the above example, 6.75% has a "par" price, which
means it has a zero cost. The lower in rate you go, the higher the cost,
or "points." A point is equal to one percent of the loan amount. The
parentheses in the cost column for the higher interest rates indicates a
negative number. For example, (1.500) equals -1.500, which means instead
of having a cost associated with the loan, the lender is willing to pay
out money for those interest rates. This is called "premium" or "rebate"
pricing.
-- Zero Cost Loans --
How Mortgage
Companies and Loan Officers Make Money
The above rate sheet is
not a rate sheet designed for public review. In fact, most lenders have a
policy that the public cannot see their internal rate sheet. This rate
sheet is designed for loan officers and the cost column is the loan
officer's cost, not the cost to the borrower. When the loan officer quotes
you an interest rate, he will add on a certain amount, usually one to one
and a half points. Most companies leave it up to the loan officer's
discretion how much to add on to the base cost. However, they usually
require at least a minimum add-on, which is usually one point.
The
loan officer's commission depends on his "split" with the company and can
vary. He receives a portion of the add-on and the rest goes to the
company.
If we assume the loan officer is adding on one point, and
you were willing to pay one point for your loan, then your rate would be
(according to this rate sheet) 6.75%. You would pay one percentage point
and receive an interest rate of six and three-quarters. If you wanted a
lower rate and were willing to pay two points, you could get six and a
half percent. If you wanted a "no points" loan, then your rate would be
seven percent.
The loan officer and the mortgage company would split
the one point rebate, listed as (1.000) on the rate sheet.
See
how it works?
In addition to the cost noted on the rate sheet
above, lenders have certain other fees they like to collect, too. These
can include document fees, processing fees, underwriting fees, warehouse
fees, flood certification fees, wire transfer fees, tax service fees, and
so on. Usually, you will not be charged all of these fees, it is just that
different lenders call them different things. Some of them are legitimate
costs to the lender and some of them are simply fees designed to generate
additional income to the mortgage company. They are customary in today's
mortgage market and can vary from around $600 to $1300. In addition, there
will usually be an appraisal fee and a credit report fee. Appraisals and
credit reports are usually contracted out to independent companies even
though these are considered to be lender fees.
Note that it is
common for companies who charge higher fees to have a slightly lower
interest rate and companies that charge lower fees will usually have a
slightly higher interest rate. So if you shop entirely based on fees, you
may actually spend more money in the long run because your interest rate
may be higher.
The point is that if you want a "no points - no
lender fees" loan, then on our rate sheet above, you may get an interest
rate of 7.125%. That is because the loan officer has to bump the interest
rate even further than on a "no points" loan in order to cover his own
company's fees.
If you want a "no cost" loan, then the loan
officer has to bump your interest rate even further. That is because all
of the costs on your purchase or refinance do not come from the lender.
The escrow or settlement company involved in your transaction will charge
a fee which must be paid. The lender will require title insurance and the
title insurance company charges a fee for providing this insurance. If
your new lender requires information from your homeowner's association (if
you have one) then the homeowner's association will most likely charge a
fee for providing those documents. If you are refinancing, your current
lender will usually charge at least two fees: a "demand" fee, and a
"reconveyance" fee. The demand fee is charged simply for providing payoff
information. The reconveyance fee is charged because your current lender
prepares a document which releases your property as collateral for their
outstanding loan. This document is called a reconveyance.
These
charges will add about another point to how much the loan officer must
collect in premium pricing in order to cover the costs associated with
your refinance or purchase. For a zero cost loan, he will normally need to
collect somewhere in the neighborhood of two and a half points. Because
points are a percentage of your loan amount and most of the costs are
fixed, it takes fewer points to provide zero costs on higher loan amounts.
On smaller loan amounts it takes more. One percent of $200,000 is two
thousand dollars and one percent of $100,000 is only $1000, so you can see
how it is easier to cover costs on larger loans.
Does it makes
sense to do a zero cost loan?
On a $200,000 thirty year fixed
rate loan, the difference in monthly mortgage payments will be about $87,
using the example rate sheet on the first page. Over thirty years, it
works out that you will pay more than $30,000 extra for getting a zero
cost loan. So if you intend to remain in the home for a long period of
time it just doesn't make sense.
Suppose you intend to stay for
only five years? On a purchase, using the $200,000 example, if you stayed
longer than fifty-five months, it would make more sense to pay your own
costs and get the lower interest rate. If you kept the loan for a shorter
time, then it makes more sense to pay zero costs and get a higher interest
rate.
Except for one thing.
If you knew you were only
going to be staying in the home for five years you would probably not want
a thirty year fixed rate, anyway. You would get a loan which has a fixed
payment for the first five years, then convert to an adjustable or
whatever fixed rates are five years from now. These loans have an interest
rate almost a half percent lower than thirty year fixed rate loans. Since
it is practically impossible to do a zero cost loan on this type of loan,
you would have to compare a zero cost thirty year fixed rate loan to
paying points on a loan with a fixed payment for five years.
The
difference in payments would be about $150. The two and a half point
rebate equals $5000. Working out the math, if you stayed in the home
longer than thirty-three months, it would make more sense to pay the
points and get the loan with the five year fixed rate.
Finally,
carry the discussion one step further. Suppose you know you are going to
be in the new loan for less than three years? Doesn't it make sense to get
a "zero cost" loan then?
No.
Then you get an adjustable
rate loan. As long as the start rate is two percent lower than the current
fixed rate, you cannot lose. The first year you will save a lot of money.
The second year you will probably break even. The third year, you will
probably give up some of the savings from the first year, but not all of
them.
"Zero cost" loans just don't make sense for homebuyers.
But they sound really good in an advertisement.
Exceptions:
- On a FHA Streamline Refinance Without an Appraisal (not a purchase -
which is what the article talks about), it makes sense to do a zero cost
loan. This is mostly because the new loan has to be exactly the same
amount as the existing balance of the current loan.
- If the homebuyer only has enough money for down payment and none to
cover closing costs, PLUS no arrangement can be made for the seller to
pay closing costs, then zero costs may make sense (however, I would
still recommend negotiating terms with the homeseller - be willing to
pay a higher price in exchange for the seller paying your
costs)
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