You always hear about the no cost loans or no cost refi’s. When the fact really is no such loans exists! There are always costs, appraisal fees, closing fees, title insurance, processing and flood certification letters. You also have recording 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 and you either pay a higher interest rate or they add that amount to your loan if you are refinancing. All a no-cost loan means is that there is no cost to you, the borrower.
Does it make 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 that has a fixed payment for the first five years, then convert to an adjustable rate 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 $5,000. 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?
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 it.
Zero cost loans just don’t make sense for most homebuyers.
But they sound really good in an advertisement!
- 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 a down payment and none to cover closing costs, PLUS no arrangement can be made for the seller to pay closing costs, then zero cost may make sense. (However, I would still recommend negotiating terms with the seller - be willing to pay a higher price in exchange for the seller paying your costs.)