Whats the real cost of a nocost mortgage

Mortgage lenders know that garbage fees and excessive closing costs rankle many borrowers. They also know that cash-short borrowers would really grab the chance to avoid this heavy burden of fees that add to the amounts already set aside for reserve funds, escrow deposits, and down payment. Thus was born the so-called no-cost (or no fee) mortgage (or refinance). With the no-cost loan, you pay a higher interest rate. For many borrowers, this trade-off sounds pretty attractive. But before you take the bait, run the numbers.

Does No-Cost Save You Money?

Of course no-cost doesn't really mean zero closing costs. Instead, it means "pay me later" rather than "pay me now." Given the fact that you're going to pay one way or another, you must determine which turns out better— paying now or paying later.

How Lenders Price No-Cost Loans

As you know (Secret #24), lenders typically give borrowers a range of discount point/interest rate trade-offs such as those shown in Table 8.2.

Although you may not see it, the loan rep's 30-year fixed-rate sheet may also show a no-cost loan as follows:

Rate (%) Discount Points

If you're quick with numbers, you can instantly spot the way the lenders have stacked the no-cost numbers in their own favor. At interest rates between 6.25 and 7.0 percent, you pay closing costs plus one point for each .25 percent that your rate drops. Because lenders know that some

Table 8.2 30-Year Fixed

Rate (%) Discount Points

borrowers can't resist immediate gain (no closing costs) in return for long-term pain (an 8 percent interest rate), they sometimes price the no-cost loan to extract more money from borrowers who choose this option.

For example, if to buy the interest rate down by .25 percent, you pay a full point, "buying up" the interest rate means the lender should credit you 1.0 point for each .25 percent increase in rate—or, in this example, 4.0 points as opposed to only 2.5 points.

Perhaps you agree to an 8.0 percent, no closing cost $300,000 loan. The lender priced the discount points at a negative 2.50 (-2.50). At settlement, the lender waives all fees up to $7,500 (2.5% x 300,000). The final accounting shows that your fees for this loan (had you paid them in cash) would have totaled $5,250.

Do you receive that $2,250 difference ($7,500 - $5,250) as a cash back credit at closing? Not likely. Instead, the loan rep and lender (in some agreed proportion) will split this overage. Your zero-cost loan gives you a money-losing trade-off.

The Potential High Cost of No-Cost

Unless you pay your loan off within about three or four years, the negative points will yield the lender a sizable return from the extra interest it collects as a result of the higher rate you've agreed to pay. With a $200,000 loan, for example, your payment runs $1,468 per month at 8.0 percent. At an interest rate of 7.0 percent, you would pay $1,331 per month. The 8.0 percent loan costs you an extra $137 each month. If your cash closing costs would have totaled $4,250, the lender needs you to keep the loan for at least 31 months ($4,250 ^ $137 = 31).

If you keep this loan for 84 months (7 years), the lender collects, roughly speaking, an extra $7,000.2 Although the mid- to longer-term economics of a no-cost loan greatly favors lenders, cash-short borrowers and short-term borrowers still might find the loan attractive. If you're tempted to go for this trade-off, run the numbers. Figure out how long you must keep the loan before it turns against you.

In periods when interest rates are trending down, serial refinanceers love this loan—and profit from it—as they ride the trend down with multiple no-cost refinancings. But at some point, the trend reverses. That's when you want to bite the bullet, pay discount points and closing costs, and enjoy the lowest interest rate you can get—from now until the foreseeable future. Without a short-term exit strategy, you will pay a steep long-term price for your no-cost, higher interest rate loan.

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