Beware “No Cost Refinance” Loans

Anybody who’s ever been in the market to refinance their mortgage (like me) has come across some sort of “no cost refinance” offer.  Whether pitched to you by a mortgage broker or via unwanted solicitation in the mail, no cost refinance loan offers all have one thing in common:  the idea that you are somehow getting something for nothing.  Unfortunately, the old “if something seems too good to be true…” adage applies here quite well.

There Is No Such Thing As A No Cost Refinance

A “No Cost Refinance” loan is one where the lender or broker promises to cover the closing costs on your new mortgage.  Seeing this, many people exclaim “free money!” and become anxious to sign on the dotted line, which is of course exactly what these no cost refinance lenders are banking on.  The reality of the situation is that there is no such thing as a no cost refinance.  You will most definitely end up paying closing costs, albeit indirectly.

How No Cost Refinance Loans Are Marketed

No cost refinance loans are generally marketed as being for low-income homeowners who want to take advantage of lower rates but don’t necessarily have the cash on hand to pay closing costs.  These types of “no cost refinance” loans probably contributed mightily to the real estate bubble, encouraging homeowners to borrow against their home equity to fund consumption when they might not have been able to afford to do so otherwise.  The pitch was usually something like “if your current mortgage is 6% and you can refinance to 5.5% using a no cost refinance, what do you have to lose?”  In reality, you have plenty to lose.  I repeat, avoid these types of mortgages at all cost.

How No Cost Refinance Loans Really Work

Ignoring the fact that if you can’t spare a few thousand dollars to cover closing costs you probably can’t afford to own real estate to begin with, this presents an interesting paradox.  Closing costs and loan origination fees are the main sources of profit for mortgage lenders.  Sure, there’s profit in bundling mortgages to sell to investors but eliminating closing costs would severely cut into mortgage lenders’ margins.  So why would a mortgage lender choose to cut their profitability by getting into the no cost refinance business?  If your answer was “they’ll just think up a sneaky way to get that money back” pat yourself on the back.

Since mortgage lenders aren’t charities, it’s safe to assume they aren’t going to do anything that costs them money.  Homeowners will end up paying closing costs on these “no cost refinance” loans one way or another, it just might not be so obvious.  One common practice is to add closing costs to the amount borrowed and roll them into the mortgage to be repaid over the standard 30 year term.  In this instance, “no-cash refinance” is probably a better term since closing costs are clearly disclosed and paid by the borrower, just not upfront.  There is absolutely nothing wrong with this type of arrangement provided you’ve done the math and know your break-even point.

Other more sneaky tactics include charging a higher interest rate on “no cost refinance” loans and then offering to let the borrower buy down the rate by paying points on the mortgage.  Since the borrower is paying points and not closing costs, the lender can get away with calling it a “no cost refinance” even though paying points amounts to the exact same thing.  Thus, the borrower thinks he’s getting a deal, the lender gets perhaps more customers than they otherwise would, and the charade is preserved.

At the end of the day, you should listen to your mother’s advice:  if something sounds too good to be true, it probably is.  “No cost refinance” loans are a perfect example.