No Closing Cost Mortgages- Are They Really No Cost?
I’m sure you’ve heard the sayings: “If it seems too good to be true, it probably is”, and “Nothing in life is free”. So, how can a no closing cost loan really be no cost? There’s got to be some costs hidden somewhere, right?
I have two goals I’d like to accomplish with this article:
1-Explain how no closing cost mortgages work- Yes, there really are no closing costs, and…
2-Explain how mortgage lenders get paid
Let’s tackle how mortgage originators get paid first because that will help with explain how no closing cost mortgages work. I’m going to use the term mortgage originators, but am including retail loan officers that work with banks as well as correspondent lenders and mortgage brokers.
Mortgage originators can get paid either through an origination fee, paid by you, the consumer or they get paid a commission from the bank through selling you a higher interest rate or they can get paid a bit of both. I’m going to go further in depth on this in a minute.
Let’s think about interest rates and the cost for each rate on a sliding scale with the par rate or base rate in the middle. The par rate is lowest rate that a bank if offering without paying discount points to buy the rate down. The par rate will typically have an origination fee associated with it because the bank is not paying any type of commission at this rate.
For example’s sake, let’s say the par rate today on a 30 year fixed is 4%. Interest rates above 4% will pay a commission. The higher the rate, the higher the commission for the loan officer. Interest rates below 4% will cost you discount points in addition to the origination fee. A discount point is a percentage of your loan amount. So, if you wanted a 3.75% interest rate, the discount point may be .75%. With a $200,000 loan amount, that .75% would cost you $1500 in addition to the typical 1% origination fee. Now, whether or not it makes sense to pay a discount point will be covered in another article as I will be discussing not paying closing costs in just a bit.
So, the question you ask is…”Which rate do I choose? How much should I pay in closing costs?” Just about every customer I work with tells me that they want the lowest rate with the lowest closing costs. I want to respond…No kidding. That’s what everyone wants. But does it make sense to pay closing costs? Let’s think about this…
I will first explain how a no closing cost loan works. Above, I explained that the higher the interest rate above the par rate, the higher the commission. A no closing cost loan is simply where you have a slightly higher interest rate and the mortgage originator uses a portion of the commission that is paid by the bank to pay for your closing costs. Now, I’m sure you’re going to say- “Well, if I have a higher interest rate, I will be paying a lot more interest over the term of the loan”. And I would respond…”Yes, that would be true if you kept this loan for the next 30 years or whatever the term of the loan is”. What is the likelihood of that? The average life of a mortgage is 3-5 years (estimated by Douglas Duncan, chief economist at the Mortgage Banker’s Association of America). So you must look at breakeven points and how long it will take you to breakeven paying costs in comparison to not paying closing costs. I’ve put together a simple comparison below.
Example: Mr. & Mrs. Homeowner are buying a new home for $300,000 and putting 20% down giving them a new loan amount of $240,000. They have a choice of paying closing costs or not paying closing costs. This is how their options may look.
Purchase Price $300,000.00
Option one: 30 yr fixed with $3500 in closing costs
Interest rate: 4.0%
Monthly payment based on $240,000 loan amount: $1145.80
*This option has the lowest 30 yr fixed rate without paying discount points to buy the rate down.
Option two: 30 yr fixed with $1950 in closing costs
Interest rate: 4.25%
Monthly payment based on $240,000 loan amount: $1180.66
*The option has $0 origination fee and a slightly higher interest rate. The difference in payment between this option and option one is $34.86. This gives you a 45 month breakeven point if you were to choose option one.
Option three: 30 yr fixed with $0 in closing costs
Interest rate: 4.5%
Monthly payment based on $240,000 loan amount: $1216.04
*This option has $0 in closing costs. It allows you to refinance again at $0 cost should rates drop. The difference in payment between this option and option one is $70.25 which gives you a 50 month breakeven.
As you can see, with both options two and three, it would take them around 4 years to breakeven and recoup the closing costs they paid in option one to have the slightly lower monthly payment. A lot can happen in 4 years. Also, the 4 year breakeven point doesn’t take into account the time value of money which will actually lengthen the breakeven point.
Interest rates are a traded security similar to stocks. So, if you’re going to pay closing costs, you’re essentially saying that you’re betting that you are buying the rate at the lowest point. Very similar to wanting to buy a stock at it’s low point. Now, many mortgage professionals have access to economic reports, bond quotes, as well as bond forecasting which lets them know what bonds are doing now and where they may be headed based on economic information that is released weekly. But are these tools foolproof? No, they are not. There is absolutely no way to time the market perfectly. This is especially true when purchasing a home as there is a specific timeframe one must close in which prevents you really being able to try and time the market. This is the first reason that I do not think it makes sense to pay closing costs.
Reason # 2 is that the bond market, which is what interest rates are based off of, are cyclical just as the stock market is cyclical. There are small cycles every 3-6 months and then larger cycles every 3-5 years. If you don’t pay closing costs, you can refinance again typically at no cost every time the rates drop a minimum of .125%. Since you’re not paying costs, any interest savings is immediate. With this, you can use the market cycles to your advantage.
Reason #3 I recommend no closing cost loans is because life happens and you don’t ever know where it will bring you over the next 4 or so years. You may have a child and move unexpectedly into a lager home. You may be facing a possible layoff and need to increase your monthly cash flow by moving to a 30 year term, or you may receive a promotion and decide you want to pay off your mortgage more quickly by moving to a shorter term. You could get relocated by your employer. Not investing thousands of dollars in closing costs allows you the flexibility to move in and out of loan programs as your life needs change.
There is one last point I’d like to make that many people seem to get confused with. A no cost mortgage is where the closing costs are paid by the mortgage originator. They ARE NOT rolled into the loan. Many un-professional mortgage originators advertise this type of mortgage as no cost or no out of pocket expenses. They are really just hiding the costs in the loan amount so please don’t be fooled by this.
I hope this article has helped to clarify no closing cost mortgages and answer any questions that you have.