While buyers avoid overcharges, they also pay a higher interest rate
By Jack Guttentag
“Is shopping for a no-cost mortgage a good strategy in today’s market?”
No-cost mortgages are relatively easy to shop because of their simplicity, and this is as true today as it was when I last visited the question in 2004. Greater simplicity increases the likelihood of finding a better deal or avoiding a worse one. Yet borrowers who expect to have their mortgage for a long time may be ill-served by a no-cost mortgage and would do well to consider an alternative strategy.
What are no-cost mortgages?
A no-cost mortgage is one on which the lender pays the borrower’s settlement costs, including the mortgage broker’s fee if there is one, with the following exceptions:
- Per diem interest, which is interest from the closing date to the first day of the following month;
- Escrows for taxes and insurance, which are borrower funds set aside to assure payment of the borrower’s future obligations;
- Homeowners insurance;
- Owner’s title insurance;
- Transfer taxes charged by governmental entities.
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
No-cost mortgages don’t eliminate costs to the borrower; they convert them from costs paid upfront to costs paid over time in the interest rate. 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: 4.25 percent with zero points; 4 percent with 1.5 points; and 4.75 percent with a 2.125-point rebate. Points are upfront payments — one point is equal to 1 percent of the loan amount. Borrowers pay points to the lender, but lenders credit borrowers for rebates.
Let’s 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, including the lender’s own fixed-dollar fee. He thus charges Doe 4.75 percent for a no-cost loan. The rebate of 2.125 points at 4.75 percent is $4,250 on a $200,000 loan, or enough to cover the $4,000.
No-cost mortgages help 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 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 study of brokered loans by Susan Woodward some years ago showed that total settlement costs including broker fees were $1,500 lower on no-cost than on other loans. While no breakdowns were available, it is likely that most if not all of the $1,500 saved was a result of lower broker fees.
Borrowers with long time horizons might do better with a different strategy
The benefit of the no-cost loan stems from the ability to avoid overcharges by shopping a simpler transaction. However, the cost of the higher interest rate on the no-cost loan mounts over time, and at some point the costs will exceed the benefit. If overcharges can be avoided, a borrower with a long time horizon will do better paying higher settlement costs in order to get a lower interest rate.
Such borrowers need an alternative strategy that will both assure competitive pricing and allow them to select the combination of upfront costs and interest rate that provides the lowest cost over their time horizon. Such a strategy can now be executed on my website, www.mtgprofessor.com.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.