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No-Cost Mortgages

No-Cost Mortgages

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




Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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