Just about every person in the world likes to get something for nothing. I’m reminded of a saying one wise man once said to me and it was “there’s no such thing as a free lunch.” That wise man was my dad.
So why would anybody think they are going 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 mortgage companies.
Do You Work For Free?
I bet the answer is no. And what you need to know is there are more people than the mortgage banker working on your loan. Besides them there is a:
Document Specialist -Verifies you sent in the correct forms with your application documents.
Underwriter – They read your paystubs, W2’s, asset statements, etc. and match everything up with your application.
Appraiser – They are called to value your home.
Fraud Specialist – They make sure the i’s are dotted and t’s are crossed while the loan is in process.
Closing Team – They call you to schedule a closing.
Notary – They come to your house to walk you through the closing documents.
There might be more or less than the 7 people listed here depending on the mortgage company you work with. As you have figured out already, they do not work for free. And the company has bills of their own to pay like electricity, heating, water, salaries, 401k’s, coffee, etc.
Why Do They Say No Closing Costs Then?
Its a play on words that many mortgage bankers and mortgage brokers say to get you to do business with them.
What they are really saying is “no out of pocket costs if we can roll the costs into the loan”.
You do not know there are any costs until you are sent the Good Faith Estimate and it lists the costs to do the loan.
Since you are not writing the mortgage company a check to pay for the closing costs it does not feel like you’re paying closing costs. But you are. And now your paying interest on them when you roll them into the loan.
Typical Closing Costs
Closing costs vary from place to place. If you do not count the “state tax stamp fees” in states 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. Some states like New Jersey make an attorney be present to sign at the closing table and we know attorneys are not cheap.
I hope you realize no closing cost mortgages do not exist now.
There Has To Be No Closing Costs Someway, Right?
There is and it involves doing a little trick with an interest rate.
Every day 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.
Call a mortgage company and ask what the zero point interest rate is on a 30 year fixed rate mortgage where 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.
As an example:
Pay one point (1%) of the loan amount, ie. $150k loan x 1%= $1,500 in additional costs. Paying points is a tax write off so the majority of the times it makes sense but pay attention to your break even point. Now you have $1500 + closing costs which probably equals $4000 just to close on the mortgage.
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. To drop the interest rate 1% you will probably have to pay 1.5 – 2 points to get it. Now we understand how paying points works.
So how is it that a mortgage company can offer a no closing cost loan? We know the mortgage company can charge points for you to get a lower rate but did you know they can give you money back for taking a higher interest rate?
This little trick is called the yield spread premium. Here is how it works.
If a mortgage banker offers you a higher interest rate than the zero point rate and you take it they earn extra money because the rate is higher 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. Take $150k x .5% = $750. They earn as extra $750 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.
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 who sit back and collect interest from your payments.
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 banker wants to do this because this is more money.
Real quick with same scenario at $400k x 2% = $8000. Yield spread premium 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.
Rarely does the scenario above happen.
Most consumers will not take the higher interest rate. So now the mortgage banker has to offer the same as every other company or lose out on business all together. Some business is better than no business.
But a smart mortgage broker will say “I have an idea that a lot of my financially savvy clients do.” Of course you want to be financially savvy so you listen.
Take the $150k example above with the $750 bonus. Let’s make this mortgage work for you 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 banker 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 not taking cash out) and your mortgage company will absorb the closing costs to do the loan.
Most people roll the costs of the loan into the mortgage. When you roll those costs into the mortgage you are technically financing $2-$4k in costs over 30 years at the lower interest rate.
By taking the higher interest 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 and at 6% its $900. $97 in interest is what you are paying more a month and over a year $97 x 12 = $1164. Your break even point is about two years.
But this is wrong.
The loan would be $148k because the $2000 closing costs were rolled into the example above to give it a $150k loan. And without those we would do $148k at 7% = $984 a month which is $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.
What the mortgage banker did was gave you their bonus money. Closing costs were $2k and they are still 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 the bonus money went to cover the costs of the loan.
On your Good Faith Estimate you will see a line item saying “Lender Paid Credit ” of $2250. They will probably move it to exactly $2000 because that’s all they need to cover the costs pocketing some bonus money of $250.
Everybody is happy because the mortgage banker still made a sale. You saved $2k in closing costs on your new loan and $2k in equity in your house from not rolling costs into the loan.
While I have shown that no closing costs mortgages do not exist it does not mean you cannot get them paid for by the mortgage company. Next time your shopping for a mortgage ask the mortgage banker how high of an interest rate you would have to take for them to pay the closing costs and see if it works for you.