It sounds perfect: You refinance your home and skip the lender fees, title charges and appraisal costs. But "no-cost" refinances can actually cost you more if you don't know what to look out for. New laws have changed the way you should shop for your refi.
One of the biggest drawbacks to refinancing, even when you know it will save you a ton of money down the road, is the initial cost. Many advisers will tell you to expect your costs to range from 3 percent to 5 percent of your mortgage amount. On a $400,000 mortgage, that's $12,000 to $20,000! That upfront amount would make anyone think twice. So when a mortgage lender advertises a "no-cost" refinance, who wouldn't be interested?
No-cost? How does that work, anyway?
Lenders get paid for making mortgages. Obviously they have to be compensated in one way or another or they'd not bother to be in business. So a no-cost loan must be paid for somewhere. When a broker sells a loan to a wholesale mortgage lender, the price is determined by the interest rate. "Par" pricing refers to the interest rate at which the wholesale refinance lender pays the broker nothing, and the broker pays the lender nothing. In that case, the borrower covers the fees.
If you want a rate lower than the par rate, you have to pay extra. The extra fees are usually called "discount points" because you are purchasing a discounted mortgage rate. If you don't want to pay loan fees, the rate can be increased. In that case, the wholesale lender pays the broker a rebate, or yield spread premium (YSP). The broker then uses the rebate to cover the loan costs. Loan officers at banks work pretty much the same way, but in that case the bank covers borrower costs in exchange for a higher rate. See for yourself what a no-cost refinance will cost you.
No-cost vs no out-of-pocket cost
What if you don't want to bring money to the refinance but you want the best mortgage rates possible? You can do that if you have enough home equity. You choose the rate you want, then have all the mortgage refinance costs rolled into the loan, so there are no out-of-pocket costs to you. This may be a better route if you plan to keep your home for many years; using par or rebate pricing may be best for those with shorter time frames. HSH.com's new Tri-Refi Calculator can help you see which option saves you the most.
So, how does "no-cost" become "cost-more?"
In a 270-page study on mortgage costs, HUD determined that when typical borrowers don't pay their mortgage costs in cash, they pay more. This is probably because when the money isn't coming directly out of pocket, there is less motivation to shop for the best mortgage rates. So, not all of the YSP may be used to offset fees and there may be a lower rate left on the table.
That should not happen in the future. Collecting excess YSP, that is, a rebate not used to cover fees for borrowers, is now illegal. The results of this study may have contributed to Congress's decision to end the practice of rebate pricing when there was no benefit conferred on the borrower.
In a move that seems to go against its conclusion about no-cost loans, HUD actually recommended in that same study that borrowers request no-cost pricing when shopping for refinance mortgages. The idea is that if you didn't have to worry about costs at all, it would come down to only comparing mortgage rates. Comparing the annual percentage rate -- a calculated rate which includes certain costs but can be misleading -- would no longer be the recommended method of shopping for a loan.
New disclosures make shopping easier
Since January 1, 2010, lenders have to honor the fees disclosed in their Good Faith Estimates. This makes lenders stick to their initial mortgage quotes to a greater degree and thus changes the way you shop. Ask several mortgage lenders for mortgage quotes based on your loan amount, property value, property type and location, and credit score. You'll probably get par pricing, with an origination fee (usually one point), and some title and escrow charges. If the fees are all coming in at about the same amount, and you plan to wrap them into the loan amount or pay them in cash (and the rate is satisfactory), choose the best rate and lock your loan.
If you want a lower rate, go back to each lender and ask for a quote based on the rate that you want. The new Good Faith Estimates requires that lenders disclose the total of all points and fees, allowing easier comparison. Then, having equalized all quotes, select the loan with the lowest cost. If you want to pay nothing, ask them all for no-cost options, and choose the lowest rate.
