Have you seen mortgage lenders advertising no cost refinance loans? This mortgage program claims that you’ll pay no fees out-of-pocket when refinancing your home loan. No cost refinance offers are nothing new; however, it’s important that you know that you’re getting yourself into before choosing this type of program. Here’s the truth about no cost refinance offers you need to help make an informed decision without overpaying.
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The No Cost Refinance Myth
The bottom line is that there is no such thing as a no cost refinance loan. There is only what’s known as no out-of-pocket expense home loans. What’s the difference you ask? Every mortgage loan has fees that get paid one way or another, the difference is what you’re giving up to get your fees paid.
No matter what mortgage program you choose there are fees that have to get paid and this is also true of no cost refinance loans. For example with the exception of government refinance programs, most lenders require an appraisal before refinancing your home. Appraisals are done by a third party and the person or company performing your appraisal has to be paid.
The person or company arranging your home loan works for a loan origination fee. In a country where you can’t throw a rock without hitting an attorney if there are any legal fees to be paid you can bet the attorney won’t work for free.
The point here is that even though your bank or lender is advertising no cost refinance loans, truth be told they simply do not exist.
How Do No Cost Refinance Offers Work?
The truth of the matter is that every mortgage costs money to close, so what are no cost refinance offers really?
As I mentioned the no cost refinance offers you see advertised are really no out-of-pocket expenses home loans. What this means is that the closing costs are paid in one of two ways.
The most common way you’ll get no cost mortgage refinancing is to have all of your closing costs rolled into your mortgage balance. This means that you’re financing your closing costs, paying additional finance charges and losing equity in the process.
This might be an attractive offer which gives you access to the lowest refinance rates and a lower payment; however, you’re giving up equity in the process. In a down market this is a risky proposition that could result in you owing more than your home is worth, something underwater homeowners have struggled with for years since the housing bubble burst.
The second no cost refinance option uses something called Yield Spread Premium to pay your closing costs. Many homeowners incorrectly assume Yield Spread Premium was outlawed by the government; however, this is simply not true. Yield Spread Premium is disclosed on page two of your Good Faith Estimate.
Yield Spread Premium Definition
Simply put, Yield Spread Premium is a cash credit you receive from the lender for accepting higher than market refinance rates. This credit can be used to pay your loan origination fee and other closing costs.
You get higher than market refinance rates which means a higher monthly payment. Yield Spread Premium works much like discount points in reverse. Typically for every .25% higher your refinance rates you get one percent of your mortgage balance applied to the settlement costs.
Take a look at page two of your Good Faith Estimate to see Yield Spread Premium in action. Item two under “Your Adjusted Origination Charges” reads “You receive a credit of $ for this interest rate of %. This credit reduces your settlement charges.” This “credit” is the Yield Spread Premium generated by quoting higher than market refinance rates.
Is accepting Yield Spread Premium on a no cost refinance offer worthwhile in the long run? It depends on your situation but you can use a simple mortgage calculator like the one below to figure out how much your payments will be with and without the markup. Extrapolate the difference in your payments over five or ten years (the average homeowner refinances every 4-5 years) and you can see how much not paying your closing costs is really costing you.
Simple Mortgage Calculator
Which is the better choice for your home loan? If you’re strapped for cash and need a lower payment you can avoid losing equity by accepting the higher refinance rates that come with Yield Spread Premium. If you want the lowest possible interest rates and don’t mind losing equity rolling the closing costs into your loan balance is an option.
Common Mortgage Mistakes
Just because you’re opting for no cost refinancing doesn’t mean that you don’t have to shop around. The amount of your loan origination fee and things like processing and administrative fees affect how good of a deal you’re getting.
Getting the lowest refinance rates might seem like the goal here; however, fixating on interest rates at the expense of fees results in overpaying things like your loan origination fee every time.
How to Shop for a Better Deal
The first step in refinancing your home loan is to pick a program and stick with it. If you need a 30-year, fixed rate, no cost refinancing, don’t let a fast talking broker confuse you by quoting interest rates from different programs.
Second, use page two of your Good Faith Estimate to compare the origination fee, lender fees, and Yield Spread Premium credit from a variety of lenders. The lower your closing cost the less of an increase you’ll see in your refinance rates to cover the fees.
The loan origination fee is one of the largest expenses you have direct control over the amount you’ll pay. Many loan officers will tell you that one percent is standard for the origination fee; however, I’ve reviewed community based credit unions that charge as little as $400.
Shopping smartly with your Good Faith Estimate can lower your closing costs by thousands of dollars and get you the best deal on your next home loan.
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