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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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