Have you heard about no-cost mortgages? Here are the pros and cons about shopping for one in this housing market:
While buyers avoid overcharges, they also pay a higher interest rate
“Is shopping for a no-cost mortgage a good strategy in today’s market?”
No-cost mortgages are relatively easy to shop because of their simplicity, and this is as true today as it was when I last visited the question in 2004. Greater simplicity increases the likelihood of finding a better deal or avoiding a worse one. Yet borrowers who expect to have their mortgage for a long time may be ill-served by a no-cost mortgage and would do well to consider an alternative strategy.
What are no-cost mortgages?
A no-cost mortgage is one on which the lender pays the borrower’s settlement costs, including the mortgage broker’s fee if there is one, with the following exceptions:
- Per diem interest, which is interest from the closing date to the first day of the following month;
- Escrows for taxes and insurance, which are borrower funds set aside to assure payment of the borrower’s future obligations;
- Homeowners insurance;
- Owner’s title insurance;
- Transfer taxes charged by governmental entities.
Don’t confuse no-cost with no-cash
This is one of the worst mistakes a borrower can make. “No-cash” means the borrower does not have to pay the settlement costs at closing, but the lender doesn’t pay them either. The costs are added to the loan balance, so the borrower pays them over time, with interest.
Borrowers pay a higher interest rate on a no-cost mortgage
No-cost mortgages don’t eliminate costs to the borrower; they convert them from costs paid upfront to costs paid over time in the interest rate. The lender finds that rate by estimating the costs for which he would be responsible, and then finding the interest rate that justifies paying those costs.
For example, Doe is borrowing $200,000 on a 30-year fixed-rate loan. The lender’s price schedule on this loan includes the following quotes: 4.25 percent with zero points; 4 percent with 1.5 points; and 4.75 percent with a 2.125-point rebate. Points are upfront payments — one point is equal to 1 percent of the loan amount. Borrowers pay points to the lender, but lenders credit borrowers for rebates.
Let’s assume Doe wants a no-cost loan. The lender calculates that it would cost $4,000 to assume responsibility for the settlement costs Doe would otherwise pay, including the lender’s own fixed-dollar fee. He thus charges Doe 4.75 percent for a no-cost loan. The rebate of 2.125 points at 4.75 percent is $4,250 on a $200,000 loan, or enough to cover the $4,000.
No-cost mortgages help protect against being overcharged…