Even though a no-cost refinance sounds great, there’s really no free lunch.
It’s like marrying someone for their money. You might think you’re getting a great deal, but you’ll probably have to put up with your partner’s controlling, narcissistic, and disgusting ways. If you’re not physically attracted to him or her, then that’s a whole other set of problems to deal with.
OK, a no-cost refinance isn’t as bad as that. But there are always costs even if you can’t see them.
A no-cost refinance is a loan transaction in which the lender pays all the refinance costs.
Refinance costs includes: processing and underwriting fees, the appraisal fee, loan origination fees, title and escrow fees, notary fees, and courier fees.
These fees can easily add up into the thousands of dollars, making potential borrowers hesitate as to whether to go through with the refinance or not.
See some of the fees below I had to pay during my last refinance some years ago, but was mostly covered through credits.
To boost business, lenders entice potential borrowers by covering all the fees so there is no out-of-pocket cost to the borrower.
If the borrower gets a lower mortgage rate without paying any fees, then the decision to refinance becomes easier. The only factor to really consider is the time and effort it takes to refinance.
Lenders aren’t in the charity business. In fact, publicly listed financial firms have some of the largest market capitalizations in the entire S&P 500 index because they make so much money.
The way lenders make up for covering all refinancing costs is by simply charging a higher monthly mortgage interest rate.
It’s the same thing as the employer making you, the employee, feel great about their generous 401(k) matching and free or highly subsidized healthcare benefits. You might be getting great benefits, but it’s costing you in terms of a lower salary.
Mortgage rates are set in increments of 0.125% e.g., 2.5%, 2.625%, 2.75%, 2.875%, 3%, etc. Therefore, instead of paying 2.5% for a mortgage refinance with fees, your bank might charge you 2.625% or 2.75% instead if you want to go the no-cost route.
The longer you take to pay off your mortgage, the more interest income the bank will make. Banks know that on average homeowners own their homes for ~8.3 years. Therefore, they can calculate their potential expected profits with relative ease once they have enough mortgage customers.
There are different types of no-cost mortgage or refinance deals as well. It’s important to ask your lender about every variable and read the fine print.
Some lenders may just cover lender fees like origination, underwriting, and processing. While others may also include third-party costs like title and appraisal, title, escrow and so forth.
If you plan to go the no-cost mortgage refinance route, then you might as well keep things simple and ask for the lender to cover all costs. Why makes things overly complicated?
You want to stay away from lenders who attempt to nickel and dime you by covering certain fees and not covering others.
If you can’t get the lender to cover all your fees, the other option is to simply add on the fees to your mortgage balance. Over the long run, you will pay more money. But at least in the short run, you’ll be more liquid.
I’m not a fan of increasing your mortgage debt by rolling up the fees. The whole point of refinancing is to save money.
Option A) No cost refinance: 4% mortgage rate, NO fees.
Option B) Standard refinance: 3.75% mortgage rate, $5,000 in fees.
Which option do you choose?
The decision depends on the size of your loan and how long you plan to keep the loan until it is paid off. How long you plan to keep your loan depends on many life variables and your view on future interest rates.
Let’s say the loan size you want to refinance is $1 million and you plan to keep the loan for 10 years before paying it off. You plan to turn your home into a rental and build your passive income portfolio.
A 0.25% difference in interest rate is $2,500 a year in interest savings on a $1 million loan. From the bank’s point of view, if they charge the higher rate, they’ll get to make up to $2,500 more in interest income a year, depending on their cost of capital, for the life of the loan.
Over a 10 year period, if you choose Option B with the lower 3.75% rate, you will save $25,000 in interest expense. Therefore, it’s clear Option B is the right financial choice assuming all else being equal.
In a different example, let’s say you only plan to borrow $300,000. It’s your first home in a city you plan to live in for four years after which you plan to sell it and go to graduate school.
A 0.25% difference in mortgage rate is a savings of only $750 a year on a $300,000 loan. Over the four year period, you will have saved $3,000 in interest expense by selecting the 3.75% mortgage that cost you $5,000 in fees.
Given saving $3,000 is less than the $5,000 mortgage refinance cost, going with a no-cost mortgage at a higher rate makes more sense all else being equal.
Only if you decide to stay or keep the property for at least 7 years does it start making more sense to go with Option B, the lower mortgage rate with $5,000 in fees.
Psychologically, it feels GREAT to pay zero fees out of pocket. If your new mortgage rate is less than your existing rate while not having to pay any fees, going the no-cost route is the better way to go. You’ll feel like you got something for nothing, even though you know nothing is really free.
If you’re planning on moving, upgrading, or downgrading homes within five years, or if you believe rates will move lower during the duration of your homeownership, paying upfront costs for a lower interest rate is not an optimal financial move. A no-cost refinance is more appropriate if the numbers make sense.
Imagine paying $5,000 in loan fees to save $750 a year in interest expense only to sell your house one year later for a great job opportunity in a different city. You will feel pretty stupid, maybe even to the point where you decline the job opportunity that might make you a multi-millionaire. Going the no-cost route would have been a much better option.
A no-cost refinance is also good for a borrower who plans to pay down their mortgage quicker. Even though the rate is slightly higher, you might save on mortgage interest expense over the long run if you have the cash flow to aggressively pay down principal.
A no-cost loan isn’t inherently good or bad. A no-cost loan is simply an option to help banks generate more business by meeting borrower demand. If your main reason for taking out a no-cost loan is because you can’t afford the fees, then you’re likely borrowing too much and/or buying too much house.
I strongly recommend everyone make at least a 20% down payment for a property plus have a 10% liquidity buffer. In other words, if a property costs $500,000, the most you should borrow is $400,000 and still have $100,000 left over in cash or securities that could be easily liquidated. Downturns do happen.
Companies like McDonald’s long ago figured out that once they allowed for credit cards, their customers would spend on average $7 versus only $4.50 when using cash. A 55% increase in spending is huge and great for business. But spending more money is often bad for the consumer’s finances and waistline.
Never be afraid to negotiate your mortgage interest rate and your mortgage fees. The first quote is seldom ever the best quote a lender can give.
Check out Credible, one of the largest mortgage lending marketplaces where lenders compete for your business. You’ll get real quotes from pre-vetted, qualified lenders in under three minutes. Credible is the easiest way to compare rates and lenders all in one place. Take advantage of lower rates by refinancing today.
Updated for 2021 and beyond.