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July 19, 2004
"Why wouldn�t anyone in his right mind
take a no-cost mortgage if he could find one?"
Because no-cost mortgages don�t eliminate costs,
they convert them from costs paid upfront to costs paid over time. No-cost
mortgages carry higher interest rates, which may be better for some borrowers,
but not for others.
"No-cost mortgage" defined.
A no-cost mortgage is one on which the lender pays the borrower�s
settlement costs, with the following exceptions:
*Per diem interest, which is interest from
the closing date to the first day of the following month, isn�t included
because it is not known until the exact closing date is set.
*Escrows for taxes and insurance, which are
borrower funds set aside to assure payment of the borrower�s future
obligations, are not covered because they are not a cost of the transaction.
*Homeowners� insurance is not covered
because, while required by the lender, it also benefits the borrower.
Owner�s title insurance is not covered because it is optional or paid by the
seller.
*Transfer taxes, if any, are not covered
because the amount is sometimes uncertain, and it is set by a governmental
entity.
All other costs, including the mortgage broker�s
fee if there is one, are paid by the lender.
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. 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: 6.25% with zero points, 6% with 1.5 points, and 6.75% with a
2.125-point rebate. Points are upfront payments - one point is 1% of the loan
amount. Borrowers pay points to the lender but lenders credit borrowers for
rebates.
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. He thus charges Doe 6.75% for a no-cost loan. The
rebate of 2.125 points at 6.75% is $4250 on a $200,000 loan, or enough to cover
the $4,000.
No-cost loans are least profitable to borrowers
with long time horizons. The benefit of
the no-cost loan is the saving in cash outlay at the outset, while the cost is
the higher rate. The longer the borrower has the mortgage, the higher the cost.
A borrower
with a long time horizon who takes a no-cost mortgage only to save cash gets a
bad deal.
A long horizon is one that exceeds the
break-even period (BEP). The BEP
is the period during which the cost of the higher rate just equals the benefit
of having lower upfront costs. Over periods shorter than the BEP, the no-cost
loan has lower costs. Beyond the BEP, the no-cost loan has higher costs. No-cost
loans are more advantageous the longer the BEP.
I have two BEP calculators, 11a for
fixed-rate loans and 11b for adjustables. The calculators factor in the tax
benefits on interest and on points, the reduction in loan balance, and interest
loss on monies used to make monthly payments and pay points that could have been
invested.
The BEP for Doe in selecting 6.75% with a
2.125 point rebate rather than 6.25% at zero points is somewhere between 4.5 and
8 years. The exact BEP depends on Doe�s tax bracket, and on the return he could
earn on investments.
The BEP is longer if the lender marks up the
costs charged borrowers who pay the costs but not the costs used in setting the
no-cost rate. The lender in the
example assumed that he would have to pay $4,000 in costs on the 6.75% no-cost
loan. The calculated BEP assumes that Doe would pay $4,000 in settlement costs
on the 6.25% loan. However, if the lender would charge Doe $6,000 when Doe pays
his own settlement costs, the BEP rises to 6-11 years. In effect, the no-cost
loan allows Doe to avoid being overcharged.
In fact, retail lenders dealing directly with
borrowers do sometimes charge fees above the cost of providing services -- when
they can. Wholesale lenders don�t because their fees are scrutinized by brokers.
How no-cost mortgages protect against being
overcharged. In selecting a loan
provider, borrowers typically shop for rate and points, ignoring other
settlement costs. They usually find out about these costs after they submit an
application, and then they receive "estimates" that are subject to change. This
provides lenders with ample opportunities to pad their own fees and mark up
those of third parties.
When responding to a borrower inquiring about
a no-cost loan, however, lenders do not have that luxury. A borrower shopping
for a no-cost loan has only one price to consider -- the interest rate -- and
lenders have to assume that they are being rate shopped. The rates they quote,
therefore, are likely to cover their true costs, which could be well below the
costs faced by borrowers who don�t go the no-cost route.
No-cost loans can also limit broker fees.
On no-cost loans that go through brokers, the broker�s fee is an additional cost
that must be covered by the rate. This can limit broker fees because lenders cap
the rebates they are prepared to offer for higher interest rates.
A recent study of brokered loans by Susan
Woodward showed that total settlement costs including broker fees were $1500
lower on no-cost than on other loans. While no breakdowns were available, it is
likely that most if not all of the $1500 was lower broker fees.
A no-cost shopping strategy, focusing
entirely on the interest rate, works best for a refinancing borrower with a
short time horizon. On a
refinance, no-cost loans are widely available because most lenders are prepared
to assume full responsibility for settlement costs. Most of the settlement costs
on a refinance are lender fees, and the third party services that generate
charges (such as appraisal or credit) are often waived. Guaranteeing settlement
costs involves little risk to the lender.
Borrowers can shop brokers and lenders
interchangeably. They need not concern themselves with brokers� fees because the
fees are covered by the rate.
Refinancing borrowers with long time horizons
can buy down the rate by paying points while the lender pays the costs.
Decide the rate you want to pay, then
shop for the lowest points on a loan that is no-cost (except for points). This
is a "semi-no-cost mortgage". For example, you ask the loan provider "How many
points for a 6% no-cost 30-year mortgage?" This is easier than setting a certain
number of points and shopping for the lowest rate because most lenders quote
rates in even 1/8% increments whereas points can be odd decimals.
Be prepared for some funny stares, to be told
that it can�t be no-cost if you are paying points, and to be asked why you would
rather pay points than costs. Here is your answer:
"I want to pay points and have the lender pay
other settlement costs because I can lock the points with the rate, but I can�t
lock the other settlement costs."
Warning: Do not shop for the lowest no-cost
quote, select the loan provider, and then negotiate a buy-down. The negotiation
could cost you everything you gained in the shopping process.
Shopping for no-cost loans on a home purchase
is more difficult. Home purchases
involve a number of third party charges that lenders may have difficulty in
pricing. At this writing, the only lender who will guarantee settlement costs on
a home purchase is ABN AMRO at www.mortgage.com.
Assuming you meet their underwriting
requirements, finding a no-cost fixed-rate or balloon mortgage on
www.mortgage.com is a snap. While
AMRO does not quote rates on no-cost loans as such, you can find your own from
their price tables. The top line in the price table for each type of loan shows
their highest rate and lowest total cost. The total cost can be negative if the
credit offered as quid pro quo for the highest rate more than covers total
settlement costs.
For example, on the 30-year fixed-rate loan
of $320,000 that I priced, the top line showed a rate of 6.5% with a credit of
$727. That means that if I paid 6.5%, AMRO would pay my settlement costs, and
they would also pay $727 of my down payment or escrows. If I dropped to the
second line, the rate would be 6.375% and the cost $102 � not quite no-cost, but
close.
Borrowers adopting a no-cost mortgage
strategy on a home purchase would do well to begin with AMRO�s web site, unless
you are shopping for an adjustable rate mortgage (ARM). AMRO does not quote
no-cost rates on ARMs.
You can also roll your own no-cost loan at
E-Loan and Indy Mac � www.eloan.com
and www.indymac.com. Both of these lenders guarantee their own fees, but
not third party fees, which are only estimates. If the estimate turns out too
low, you will be liable for some fees you thought were covered. If the estimate
turns out too high, your costs will turn out to be lower than you expected.
This isn�t as good as having third party fees
guaranteed, but it isn�t that bad either. Since both lenders show their detailed
estimates of third party charges, you can get an idea of how large an error
might be by comparing their estimates. Unlike AMRO, furthermore, E-loan and Indy
Mac quote no-cost rates on ARMs having initial rate periods of 3 years and
longer.
If you have a long time horizon, you cannot
use these sites to obtain a "semi-no-cost mortgage," on which the lender pays
the costs other than points, and the borrower pays points to reduce the rate.
This tactic, recommended above for borrowers who are refinancing, is designed to
avoid cost escalation as the loan moves toward closing. The danger does not
arise, however, if you use lenders who guarantee their own fees.
No-cost loans, and semi-no-cost loans can be
arranged through brokers. The only cost that a broker can guarantee, however, is
her own and most brokers are reluctant to do even that. The exception is Upfront
Mortgage Brokers (UMBs), who will guarantee their own fees. Brokers also know
the fees of the lenders with whom they work, so lender fee escalation is seldom
an issue. Broker capacity to estimate third party fees will vary widely, but if
the broker�s fee is fixed, under-estimates should be no more likely than
over-estimates.
Copyright Jack Guttentag 2004
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