The Truth about No Closing Cost Mortgages

3 Replies

The Truth About No Closing Costs Mortgages

You hear about them on the radio all day long. "We'll do your mortgage with no closing cost!" And you think to yourself, "Hey, that a good deal." Well you know what the wise man say, there is no such thing as a free
lunch. There is always a catch.

No closing cost mortgages are not a new concept. Mortgage brokers have been doing them for years. It is a perfectly legal way of doing business, so long as the borrower understands exactly what they are agreeing
to. The way this works is the borrower agrees to accept a higher interest rate than they would normally qualify for in order to not have the pay any of the closing costs. The broker earns what is known as "yield
point spread" or YSP for originating the loan at the higher rate and then simply pays for the closing costs out of their commission, leaving enough left to make doing the loan worth their time. The real winners in this
scenario are the lenders, who are now making considerably more money off of the loan in interest.

Now this strategy is a good one for borrowers who are not going to hold that loan for very long. Landlords or real estate investors who only plan to hold a property for a year or two, might find it worth while to take
the higher payment and interest rate to keep from having to put out $4000 or more every time they do a mortgage transaction. Likewise for military or corporate individuals who move around every few years.

However for the average homeowner, who may keep a loan for 10, 15, or even 30 yrs or more, this strategy doesn't make much financial sense. Let look at the following example.

Take a $150,000 mortgage where the borrower qualifies for an interest rate of 7.0% The closing costs for the mortgage will be $6,000, however this borrower is offered a no closing cost deal at 8.25% interest. Now
our borrower plans to live in this house and keep this loan for at least 10 to 15 years until all of his children have gotten out of college. He could certainly use that $6,000 towards things for his family and so the deal
sounds appealing. But let's see what his benefits would be (if any) for accepting the no closing cost deal.

Option #1
Loan Amount: $150,000
Closing Cost Paid: $6,000
Interest Rate: 7.0%
Loan Term: 15yrs fixed rate
Monthly Payment: $1,348
Total interest over the life of the loan: $92,684

Option #2
Loan Amount: $150,000
Closing Cost Paid: $0
Interest Rate: 8.25%
Loan Term: 15yr fixed rate
Monthly Payment: $1,455
Total interest over the life of the loan: $111,938

By accepting the no closing cost deal, our borrower would be paying $107 more a month in a monthly payment and over $19,000 more in interest over the life of the loan. All to keep from having to make a $6,000 investment in his home when he bought it. Had he paid the closing costs upfront and taken the loan at 7.0% interest, then he would have made back his initial investment in about 57 months.

So is a no closing cost mortgage right for you? That's up to you and your current situation. Just understand that there is no free ride. You are paying for it, one way or another.

Originally posted by "JWorley":
By accepting the no closing cost deal, our borrower would be paying $107 more a month in a monthly payment and over $19,000 more in interest over the life of the loan. All to keep from having to make a $6,000 investment in his home when he bought it. Had he paid the closing costs upfront and taken the loan at 7.0% interest, then he would have made back his initial investment in about 57 months.

Hmmm, while I agree with your conclusion (that the no-closing cost deal costs more in the long run) I'm not sure I agree with the way you got there. You can't just equate a dollar today with one 57 months from now. Would paying $7000 extra in interest over 15 years be a worse deal than paying $6000 right now? Probably not.

The real question is where would that person be in 15 years if he either:

(1) took the no-closing cost loan and invested the $6000 he saved up front

or

(2) paid the $6000 and invested the extra $107 a month.

In either case, in 15 years, he would have the home completely paid off plus the value of the investment (either the original $6000 or the monthly $107). The apples-to-apples comparison would be the values of those two investments after 15 years. To do the calculation, you will have to assume a rate of return. Here's what I get for different rates of return:

If he got a 5% return he'd have:
$12,682.22 from option 1, $28,599.92 from option 2 for a difference of $15,917.69 at 15 years.

If he got a 10% return, he'd have:
$26,723.52 from option 1, $44,348.33 from option 2 for a difference of $17,624.81 at 15 years.

At a rate of 10%, the difference between the two options reaches a maximum, and the difference then heads towards zero, with the two options being equal at about a 20% rate of return and then forever favoring option 1 (the no closing cost) for rates of return above that. Here's a chart comparing the two (click for a larger image):

[URL=http://img236.imageshack.us/img236/8812/optionsqp8.jpg][/URL]

So, unless he feels he feels he can average a better than 20% rate of return over the next 15 years, its better to pay the closing costs. But each deal should be evaluated individually because the options may be different.

For example, if the deal instead were a no closing cost loan at 7.5% vs. the $6000 closing cost at 7%, the difference in monthly payments would be $42.28, or $7609 over the course of the loan. That's "more" than the $6000 up front, but any investment that yields 3.5%/yr or more would make the no-closing cost loan better, because his $6000 would grow to more over 15 years than his extra $42.28 per month would.

TN-Apprentice,

I admit that the example was simple generalization, but the point still holds true. You will pay more for the no closing costs deal over the life of the the loan and that's just something that isn't made clear to many borrowers who take them. Like I said it depends on your personal situation as to whether or not it is the right program for you. You simply take it to the next level by breaking down the ROI of the money invested or saved, assuming that the borrower uses that money for other investments (you and I both now that the majority of home owners are not going to be thinking like this, nor are they going to be financially disciplined enough to do it.)

I like the way you broke down the information though. It gives me a few ideas about how to present this information to my clients when I am trying to educate them as to their options.

When I stated that the borrower would break even in about 57 months, I was, of course, simply referring to the $107 a month savings vs. the intial $6000 investment. .

Good post. I like it. :D

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