You hear about them on the radio all day long.
"We'll do your mortgage with no closing cost!"
You think to yourself, "Hey that sounds like a good deal." But is it? Let's exam the options.
The idea of a no closing cost mortgage is nothing new. 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 YPS (this is simply a rebate paid directly to the broker, by the lender, for originating the loan at the higher rate). The broker then simply pays for the closing costs out of their YPS rebate, 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 thousands of dollars every time they do a mortgage transaction. Likewise for military or corporate individuals who move around every few years. Investment savvy borrowers may also find the no closing costs method useful for short term financial plans, where they can use the funds saved to invest in other arenas, such stocks, bonds, mutual funds, etc in order to earn a return on their money.
However for the average homeowner, who may keep a loan for 10, 15, or even 30 yrs or more, this strategy probably won'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 9.0% 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 would like to also get an investment portfolio started for his retirement and is thinking he could use that $6,000 to invest in stocks, mutual funds, bonds, etc, so he is thinking that the no closing costs deal sounds pretty good. 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: 15yr 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: 9.0%
Loan Term: 15yr fixed rate
Monthly Payment: $1,521
Total interest over the life of the loan: $123,852
By accepting the no closing cost deal, our borrower may be saving $6,000 up front, but he is also accepting a payment of $173 more a month, which will translate into over $31,168 more in interest over the life of the 15 yr loan. This would mean that the $6,000 worth of investments would have to be giving him a rate of return of better than $173/month to make the deal work so that he is not simply losing that money every month. Now on the flip side of this example, had our borrower paid the $6,000 up front in closing costs and accepted the lower monthly payment, then he would have the extra $173/month to slowly put toward his investment portfolio, plus the comfort of the lower payment in case of a rainy day down the road.
So is a no closing cost mortgage right for you? That's up to you. If you have definite short term plans for the property that you are purchasing and you have the financial responsibility to carry out those plans, then paying no closing costs may be an option for you. However if you are buying the home that you plan to live in for the next 10, 20, 30 years or more, then paying your closing costs and keeping your payment as low as possible will most likely make more financial sense for you. In either case, always make sure that you worked the numbers and explored all of your options so you can decide what is best for you. And lastly, don't let anyone get you emotionally tied up into accepting a no closing cost deal. Just remember, there is no such thing as a free lunch. You will pay for it, one way or another.
John Worley is residential/commercial loan officer with over 5 years experience in the real estate business. His background includes residential real estate appraisal and residential/commercial real estate investing. For more information on John's current mortgage services and other helpful informational articles, log on to http://www.rtlgeorgia.com/
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