The answer to this question is relatively simple once you understand how mortgage brokers and lenders earn their revenue. There are two primary revenue sources for mortgage companies: 1) through fees charged up-front to the borrower such as origination and discount fees, underwriting and administration fees, processing fees, etc.; 2) through monies paid by the “secondary market” when the originated loan is sold and/or the servicing of the loan is transferred. The fees generated through this second source are referred to as “yield spread premiums” and “service release premiums”. Understanding how these fees work is the key to understanding how a no closing cost mortgage is possible.
When you apply for a mortgage, whether for a purchase or refinance transaction, your Mortgage Consultant, aka Loan Officer, will more than likely give you a few options of different rate and closing cost combinations. The simple relationship is: Lower Rates = Higher Costs. And, conversely: Higher Rates = Lower Costs. An example will help illustrate:
Let’s say you’re looking to borrow $250,000 on a new mortgage to get a lower interest rate and save some money. You and your Loan Advisor, aka Mortgage Consultant, have determined that a 30 year fixed mortgage is the best option based on your other finances and your current plans to stay in your house until the end of time. Here are your rate and closing cost options: (it’s important to note that the originating mortgage company earns the same gross revenue amount on each of these options):
Interest Rate: Total Closing Costs: Monthly Payment:
4.25% $5,000 $1,229.85
4.375% $3,750 $1,248.21
4.5% $2,500 $1,266.71
4.75% $zero, $zilch, $nada! $1,304.11
Which one should you choose? The answer is, as you might have guessed, “it depends”. But before we explore that, let’s look at how and why the no closing cost loan is possible. Again, the second source of revenue for mortgage originators are the fees paid directly to them by the investors that ultimately buy the loans. (Even big banks like Wells Fargo and Bank of America sell their mortgages in the secondary market. They may service the mortgages – i.e. collect the monthly payments – but they don’t necessarily own the underlying asset for the long term of the loan.)
Think of a mortgage as an asset that has value for the Note holder. The value is the interest that is generated by the interest rate charged on the principal balance and paid by the borrower on a monthly basis. Investors are willing to pay money up front for that long term income stream. How much they’re willing to pay depends on, among other things, the Note rate.
In our hypothetical example above, to buy the $250,000 principal balance loan at a 4.25% return, the investor pays the originator $252,500. The extra $2,500 above the principal balance (1% of the loan amount) is the premium paid to compensate the originator for their services in originating the loan AND for the present and future value of the interest income the loan is expected to generate for the investor. For the same loan at 4.5%, the investor pays the originator $255,000 ($5,000 premium = 2% of the loan amount). At 4.75%, the investor pays a premium of $7,500 for that higher interest rate loan (a total of $257,500). Basically, the higher the rate on any given loan, the more value the loan has to the investor and the more the investor is willing to pay for it up front.
In this case, at 4.75%, the investor is paying enough money to the originator that the originator is able to pay all of the costs of origination (appraisal, processing, underwriting, title insurance and settlement services, flood certification, credit report fees, recording fees, etc.) and still make a reasonable profit. This is how a no-closing-cost loan works. Another way to think of it is that it isn’t truly a “no-cost” loan. It’s a no closing cost loan from the borrower’s perspective. Everybody from the appraiser to the title company and loan officer still has to get paid. The closing costs are just built into the transaction in the form of a higher interest rate. Instead of paying more money in closing costs up front, the borrower agrees to pay a little more each month for as long as he or she has the loan. If the borrower wants a lower rate, she has the option to pay the up-front closing costs required at that interest rate (either out of pocket or by adding the costs to the loan balance).
Getting back to the question of which option is “better”?
First, let’s look at the difference in monthly payment between the highest and lowest rate options: $1,304.11 – $1,229.85 = $74.26. That’s assuming though that you didn’t borrow more money to cover those closing costs at the 4.25% option. If you financed them, your new loan amount would increase to $255,000 and your monthly payment would be $1,254.45 per month. Now your difference in payment is just $49.66. By the way, this is one of the reasons more borrowers are choosing low or no cost refinance options. Most people can’t or don’t want to write a check for loan closing costs. The popular solution is to add them to the new loan balance. But a lot of homeowners unfortunately don’t have enough equity in their homes right now to even be able to consider that option. Property values are down. They need to keep their loan balances as low as possible to be able to qualify for the best rate options (or even qualify at all).
But let’s assume in our example that you can add the $5,000 to the loan balance and get that coveted, lowest interest rate with bragging rights. Should you do it? How long will it take you to recover the costs? A simple, though not completely accurate way to look at it is to just take the $5,000 in costs and divide them by the payment savings of $49.66 per month. That easy math shows it will take 101 months to “break-even”. That’s not a typo! It would take 8 years and 5 months to just break even! This rudimentary analysis is what most loan officers use in calculating the break-even point when paying higher costs for a lower rate.
A better analysis and one I use with my clients is to run and compare loan amortization tables and determine when the interest savings realized with the lower rate option equals the closing costs added to the loan. When using this approach, I prefer to assume that my client will take the payment savings and apply the difference toward extra principal reduction. (Whether or not they do this is of course up to them, but this gives you a truer Cost/Benefit Analysis because it puts that payment savings to work and you don’t have to worry about factoring in an “alternative use” value of that $49.66 savings. It compares apples to apples because the monthly payment amounts with each option are the same. (For you economists out there, we don’t have to worry about a time value of money adjustment either because the $5,000 closing costs have been financed.)
This is where it gets interesting! In this example, the break-even point comes down to 4 years and 7 months. It is at this point in time that the “Total Cost” of the higher rate (4.75), no closing cost option starts to become more expensive than the lower rate (4.25) option with $5,000 in closing costs added to the loan. (That’s nearly 4 years sooner than indicated by the other cost analysis where the closing costs were just divided by the monthly payment savings.)
Nevertheless, 4 years and 7 months is a fairly long time to recover closing costs. If you sold your house or refinanced again in less than that time, you would end up paying more in total interest and closing costs than you would with the higher rate, no cost option. How much would you save with the lower rate option if you sold your house exactly seven years after refinancing? The answer, once again assuming that you paid the extra $49.66 every month toward the principal, is $2,878.99. After 10 years? The 4.25% option will cost you $6,636.92 less than the 4.75% option.
The bottom line is it is crucial when you’re making decisions on your mortgage to not focus just on getting the lowest rate possible. You should consider your whole financial picture and your plans for the future, even and especially if those plans are indefinite. Most people don’t know for sure how long they plan to live in their homes or own their investment property. We don’t know where interest rates will be 5 years from now although if history is any indicator we can be fairly certain they’ll be higher than where they are now. A truly competent and conscientious mortgage consultant can help you identify and evaluate all of the important factors to help you secure the lowest total cost financing possible. Ultimately the decisions are yours to make. The value your mortgage consultant brings is in helping you make educated, strategic moves when it comes to what is likely your single largest financial commitment.
So the final answer to the question, which rate/closing cost option is best? After all that, it still depends. But the next time someone tells you, “Hey, I got a 2.5% 30 year fixed rate mortgage!”, be sure to ask them, “Really? How much did that cost you?”