March 20, 2000
"I was told that a
certain mortgage lender offering loans on the Internet provided grants to
first-time home buyers. The grants cover all settlement costs.
Is this for real?"
No. I went to the
web site you mentioned, and found a mortgage broker offering "no-cost"
loans. There are hundreds of others doing the same, off and on the web. But
there is no grant involved, and you don't have to be a first-time home-buyer to
get one.
College freshman learn in Economics 101
"There is no such thing as a free lunch." Similarly, in the home loan
market, there is no such thing as a no-cost mortgage. The borrower always pays
the settlement costs -- one wayor
another. If they don't pay it in cash at the closing, they pay it in the future
by accepting a larger loan amount or an above-market interest rate.
In the second and more common case,
mortgage brokers offering no-cost mortgages collect from the lender a fee called
a "yield spread premium"
(YSP) on a high-interest rate loan. The broker pays your settlement costs out of
this fee, and has enough left over to compensate himself. Lenders dealing
directly with borrowers do the same thing, except that there is no YSP. In
effect, they pay the fee to themselves and there is no record of it.
I dislike no-cost mortgages because
borrowers who need them almost always pay too much, for reasons discussed
below.
April 10, 2000
"You recently wrote
that "no-cost" mortgages are usually a bad deal for borrowers.
Why?"
Borrowers usually pay too much
for "no-cost" loans, which are poorly priced for cash short borrowers.
Most borrowers also don't know how to shop for them.
Borrowers pay for a
"no-cost" loan by accepting a higher interest rate than they would if
they paid points. Points are upfront fees. Each point is 1% of the loan amount.
Lenders typically offer
different combinations of interest rate and points. The higher the rate, the
lower the points. If the rate is high enough, points are negative, that is, the
lender credits them to the borrower's settlement costs. This is how
"no-cost" mortgages are created.
To illustrate, I recently
shopped 8 lenders on-line for 30-year fixed-rate loans in California. The loans
had rates of 7.5%, 8.25% and 9%. All the loans were for single-family homes for
permanent occupancy, and carried 30-day lock periods. On average, these lenders
offered 7.50% at 3.25 points, 8.25% at zero points, and 9% at -2.25 points. If
settlement costs amounted to 2.25 points or less, the 9% rate could be the cost
of a "no-cost" loan.
Borrowers elect
"no-cost" loans for two reasons. They are either short of cash, or
they don't expect to have the mortgage very long. Borrowers in the second group
minimize their upfront costs because they expect to pay the high rate for only a
short period.
Because high-rate mortgages
have a relatively short life, lenders price them accordingly. Note that
increasing the rate from 7.50% to 8.25% results in a 3.25 point reduction but
increasing the rate from 8.25% to 9% results in only a 2.25 point reduction.
The cash-short borrower who
does not expect to move within a few years thus pays a stiff price for a no-cost
mortgage.
In addition, borrowers often
leave money on the table. Suppose the rate for a "no-cost" loan is 9%,
based on negative 2.25 points. On a $100,000 loan the value of the negative
points is $2250. But if actual settlement costs are only $1800, the borrower
pays $450 too much.
Borrowers offered
"no-cost" rates by loan officers never get to see the negative point
values. They don't show up in print ads, and loan officers don't discuss them
with borrowers.
The usual practice is to select
a "no-cost" rate where the value of the negative points more than
cover settlement costs. The difference, called an "overage", is
retained by the lender or mortgage broker, and usually shared with the loan
officer.
Overages can also arise on
positive point loans, when the loan officer collects points in excess of the
points shown on the price sheets given to them by the lender or mortgage broker.
However, a study I conducted several years ago revealed that overages are
heavily concentrated in negative point loans. I suspect that borrowers who need
no-cost mortgages don't comparison shop very much. In the absence of information
on negative points, shopping wouldn't accomplish much.
But the internet has begun to
change this. A number of mortgage web sites allow consumers to see negative
points quotes. The sites refer to them as "rebates".
I particularly like the way it
is done by Iown.com, one of the multi-lender shopping sites. By clicking on the
name of the lender in a rate table, Iown shows the complete set of rate/point
combinations offered by that lender. It also shows total settlement costs, so
that the borrower looking for a no-cost loan doesn't pay a higher rate than
necessary to get it.
Other web sites that allow
borrowers to select rate/point combinations that include negative points include
HomeAdvisor.com, KeystrokeNet.com, and HomeSpace.com.
October 11, 2001 Postscript
Since writing the above, there
has been a severe shakeout in on-line lending. IOwn shut down its own
lending operation and now shows loans for Quicken Loans and MortgageSelect.
For Quicken, IOwn shows complete rate/point schedules, just as it did before for
itself. Ironically, these schedules are not available on Quicken's own
site! So IOwn remains the site of choice for this purpose. HomeSpace
and Keystroke have terminated their site, and HomeAdvisor no longer shows
rate/point schedules.
November 1, 2002 Postscript
"No-cost" does not
mean zero outlays at closing. Borrowers should always expect to pay per
diem interest, which is interest from the day of closing to the first day of the
following month. On a refinance, they will also pay interest from the
first of the month to the closing day. Borrowers will also have to pay for
escrows, though on a refinance they will get credit for escrows held by the old
lender.
February 20, 2004 Postscript
My statement earlier that
no-cost loans are often a bad deal for borrowers has to be qualified in another
important respect. Such loans make it much easier to shop. A borrower need only
shop rate on a no-cost loan, and so long as "cost" is properly
defined, there is no danger of having fees added to the pile as the loan moves
to closing.
Copyright Jack Guttentag 2004
