1. Just about every person in the world likes to get something for nothing. I’m reminded of this old saying that one wise man once said to me and that it was “there’s no such thing as a free lunch.” That wise man was my dad. So why would anybody think that they are going to be able to refinance a mortgage without paying any closing costs. This is absurd. Let me dive into this topic a little more to tell anybody who’s shopping for a mortgage what really goes on at these mortgage companies.
2. You have to ask yourself this question, “would I work for free.” The answer is no. What you do not know is that when you shop for a mortgage and choose a company to work with there are more people than just the mortgage banker who is working on your loan. It starts with the mortgage banker, then it goes to a document specialist (fancy name for somebody who makes sure you sent in all of the correct forms with your application documents), then it gets sent to a loan analyst who actually reads your pay stubs and w2’s and puts your information into a computer system to make sure everything is exactly what was put on your application documents. From there an appraiser is called and if the mortgage company does not have their own in house title company one of those has to be called to get the paper work set up to be notarized with your local government. When you count it all up there are at least 5 people who are involved with your home loan. If your lucky and are working with a great company you will only talk to your mortgage person, the appraiser just to set up the appointment, and one more person who handles your closing date and if they need anymore documents. I don’t think any of these people work for free and you know the company has bills of their own to pay like electricity, heating, water, salaries, 401k’s, coffee in the break room, etc.
3. If this is the case then why do we hear there are no closing costs loans? The answer is its a play on words that sneaky mortgage brokers/loan officers use to get you in the door. You think your getting a free loan because there are no “out of pocket costs.” Many mortgage brokers would sell you over the phone and not even talk about closing costs. You would say “are there any costs to do this loan?” Your broker will reply with,” absolutely zero out of pocket costs.” This of course sounds great and you move forward with them. You then get your application documents and on the Good Faith Estimate it shows a list of costs involved with the loan. You are confused and call up your mortgage person asking about the costs. They reply with “we just roll those costs into the loan so you do not pay anything up front.” This is sneaky but most people do not step back to think about this. All of the other companies you talked to were up front and told you about costs and this guy did not. You thought all of those other mortgage companies were going to make you pay out of pocket a couple thousand dollars which you really did not want to do. Maybe its time to stop the process with this loan officer and go back to the other people who were up front and honest and who could probably roll the costs into the loan like this person is doing.
4. Closing costs are going to vary from place to place. If you do not count the “state tax stamp fees” which only a couple states do like New York and Florida your average closing costs are going to be in the $2k-$3k range. This will cover processing fees (covers the salaries of the loan analysts, documentation specialists), title insurance (covers the title company) appraisal and other small mandatory costs like a credit report, etc. This is just to complete the transaction. Some states like New Jersey make an attorney be present to sign at the closing table and we know attorneys are not cheap.
5. I hope your starting to realize that the no closing cost myth is getting de-bunked very quickly. But there has got to be some way that there is no closing costs involved right? Well there is but you probably do not want to hear it because it involves doing a little trick with an interest rate.
6. Every day all mortgage lenders get their rates from the stock market. They base what is called their “zero point interest rate” or the market rate for the day and determine what their costs are going to be from there. If you were to call a mortgage company up and do a zero point interest rate all you would have to pay is the closing costs involved in doing the loan. You may hear things about “buying down the interest rate” or “paying points.” What this is is you can get a lower interest rate by paying a one time up front cost to the lender to get a lower rate.
7. As an example you want to pay one point which is 1% of the loan amount, ie. $150k loan x 1%= $1,500 in additional costs. When you pay points it is a tax write off so the majority of the times it makes sense but if you do this you must commit to staying in this mortgage for awhile, because their is a break even point. Now you have the $1500 + what your closing costs are which probably equals in the $4000 range just to close on the mortgage. One important thing to remember is that when you pay points it does not correlate into a 1% lower interest rate. If you were offered a 6% interest rate on a 30 year fixed rate mortgage it does not mean you now have a 5% interest rate. You are probably now going to be offered a 5.5% interest rate. I know it sounds weird but remember that paying points is a cost. More than likely to drop the interest rate 1% you will probably have to pay 1.5 – 2 points to get it.
8. Now we understand how paying points work so how is it that a mortgage company can still offer a no closing cost loan? So we know that the mortgage company can charge points for you to get a lower rate but did you know that they can give you money back for taking a higher mortgage rate? What this little trick is called is the yield spread premium. If a mortgage broker or bank offers you a higher interest rate than the zero point rate and you take it they earn extra money because the rate is actually lower than what the market is. Going with a higher rate it might give the mortgage broker a .5% kick back. As an example with the $150k loan you take $150k x .5% = $750. They earn this extra money after closing when your loan is sold on the open market. Its kind of like a way for the investors to say that if you sell a mortgage with a higher interest rate we will give you a one time bonus. Of course this is an incentive to do this because if you start looking at bigger mortgage amounts the numbers add up. Most mortgage companies when they sell their loans on the market will make 2% of the amount. Using $150 k x 2% = $3000. This is straight revenue to them paid by the investor. You already paid their closing costs separate so this is on top of that stuff. And now they get a $750 bonus to boot bringing it to $3750. Of course the mortgage broker wants to do this because this is more money. Imagine a $400k loan. Real quick with same scenario above. $400k x 2% = $8000. Yield spread premium time is $400k x .5% = $2000. $8000 to sell the note + $2000 bonus money = $10,000. All from just moving numbers on a piece of paper. Crazy huh.
9. Little does the scenario above really happen. Most consumers are smart and will be like there is no way I’m taking the higher interest rate for the same closing costs as everybody else I’ve been talking to. So now the mortgage broker has to offer the same or lose out on business all together. Some business is better than no business. A smart mortgage broker will say that “I have an idea that a lot of my financially savvy clients do.” Of course you want to be financially savvy so you listen. Remember from the above example of $150k with the $750 bonus? Let’s make this mortgage work now. Let’s say the closing costs to do the loan are $2k total (probably higher but follow me). The zero point interest rate is 6%. The mortgage broker looks at their rate sheet for the day (a mortgage rate sheet lists all available rates for all programs with points) and sees that if the client takes 7% there is a 1.5% kickback (bonus money, remember). Quick math shows us $150k mortgage x 1.5%= $2250. The loan officer says “hey client if you take a 7% interest rate with this mortgage I can do the loan with no closing costs.” You say “why would I ever want to take a higher rate, that is absurd.” You inform the client that their loan amount will stay exactly the same ( lets assume they are re-doing a adjustable rate mortgage that went to 8% or they are taking cash out and are currently in the 6%-7% range already and just need quick cash) and your mortgage company will absorb the costs on the loan. Most people roll the costs of the loan into the mortgage. When you roll those costs into the mortgage you are technically saying that you are okay with financing $2-$4k in costs over 30 years at the lower interest rate. By taking the higher rate the balance on your loan will be lower and the payments are pretty close every month. A 30 Year mortgage payment of $150k at 7% is $997 at 6% its $900. $97 in interest is what you are paying more a month and over a year that’s $97 x 12 = $1164. So your break even point is about two years. But really this is wrong. The loan would be $148k because the $2000 closing costs were rolled into the loan and without those we would do $148k at 7% = $984 a month. Which is only $84 more a month. Its still close to the 2 year time table which really is not a long time period but this is just an example of a scenario on how to do a no closing cost mortgage.
10. What the mortgage broker did was gave you their bonus money. Closing costs were $2k and they are still effectively going to get the $2250 when they sell the loan on the open market but this $2250 covers the all of the costs on the Good Faith Estimate with $250 to spare. They still get paid the normal $150k x 2% = $3000 from when they sell it but at the end of the month the bonus money went to cover the costs of the loan. On your Good Faith Estimate you will see something on a line called “Lender Paid Credit ” of $2250 ( They will probably move it so its exactly $2000 because that’s all they really need to cover the costs so they at least pocket some bonus money of $250). Everybody is happy because the mortgage broker still made a sale. You, the home owner saved $2k in costs which you do not want to roll into the loan. This scenario of a no closing cost mortgage hopefully helps you out understand how mortgage companies actually do this. I know the numbers I have above don’t really make it look like a a lot of sense to to take the higher rate but I do not have a mortgage rate sheet in front of me and do not know the exact numbers. More than likely the numbers I provided are very conservative. Your costs are probably going to be in the $3 range and to take 1% higher rate will probably cover all of those costs which makes the break even point more like 5 years instead of 2. Most people don’t stay in a mortgage for more than 3 years anyways with things changing in their lives or moving, etc. So you have to work the numbers and see what your financial goals are. I hope this example of the no closing cost mortgage myth shed some light into how the mortgage game is played.