What Mortgage Refinancing Can do for You

Imagine a scenario where you can have access to extra cash, while simultaneously lowering your monthly mortgage pay-ment. This dream can become a reality through mortgage refinancing. A house is the largest asset you may ever own. Likewise, buying a property may be the largest expense you will have in your monthly budget. Would not it be great to use this asset to reduce your monthly payment and put extra cash in your pocket? When you refinance your mortgage, you can take advantage of the equity in your home and increase cash flow.

What is a "No-Cost" Mortgage refinance any way? And does it make sense?

No-Cost Refinance Defined

A no-cost refinance is one with an interest rate high enough that the lender’s rebate covers the closing costs (but not all closing costs, see below). Rebates are negative points. Lenders charge points on low-interest rate loans and pay them on high-rate loans. For example, on a 30-year fixed-rate mortgage, they might quote 5.75% with 2 points, 6.25% with zero points, and 7% with a 1.5-point rebate. If the 1.5 point rebate covered the settlement costs, 7% could be the no-cost rate.

In sum, the borrower taking a no-cost refinance is paying the settlement costs in the rate. If he pays off the mortgage in a few years, it’s a good deal. If he has it a long time, it is a costly deal.
The Break-Even Period

The proof of the pudding is in the numbers. The critical number for potential borrowers is the "break-even period" (BEP) for a no-cost loan, relative to the same loan with a lower rate on which the borrower pays the costs. Over periods shorter than the BEP, the no-cost loan has lower costs. Beyond the BEP, the no-cost loan has higher costs.

I have two BEP calculators:

11a Break-Even Period for FRMs
11b Break-Even Period for ARMs

The calculators factor in the tax benefits on interest and on points, the reduction in loan balance, and interest loss on monies used to make monthly payments and pay points.

To illustrate, on July 10, 2004 I shopped Eloan.com, a very competitive web site, for a 30-year fixed-rate loan that included a no-cost version at 7%. I used the calculator to determine the BEP relative to a 6.375% version on which the borrower paid settlement costs, including 4/10 of a point. The comparisons were done for both a refinance and a purchase, and to make it as unfavorable as possible for the refinance, I assumed the highest possible tax rate of 39.1%.

The BEP turned out to be 40 months on a purchase transaction and 44 months on a refinance. Over periods this short, the difference in tax treatment between a refinance and a purchase does not carry much weight. The reason is that a refinancing borrower who pays off his loan in full can take the entire remaining tax deduction in the payoff year. If payoff occurs in the fourth year, the loss from deferral of the deduction is small.

At lower tax rates, the BEP is even shorter. At a 15% rate, it is 31 months on a purchase and 32 months on a refinance.
Costs That Are Covered in a No-Cost Mortgage

If you shop for a no-cost loan, make sure that you and the lender agree on exactly what it means. It is not "zero points" which leaves you responsible for other types of lender fees as well as other payments to third parties. It is not "zero fees" which still leaves you responsible for payments to third parties. And it is not "no cash" because that could mean that you are paying the costs but the lender is increasing the loan by enough to cover them. On a true "no-cost" loan, the lender collects no fees and pays other settlement costs on your behalf without increasing the loan amount.

But there are some costs for which borrowers will remain responsible. One is per diem interest, which is interest from the day of closing to the first day of the following month. On a refinance, you will also pay interest on your old mortgage from the first of the month to the closing day. Another outlay you should expect to pay is escrows, though on a refinance you will get credit for escrows held by the old lender. In addition, expect to pay homeowners insurance and any transfer taxes.
The APR on a No-Cost Mortgage

I am frequently asked whether you can tell a no-cost loan from the APR? The answer is, "yes and no". If the APR is greater than the interest rate it means that you are paying some lender fees and don't have a no-cost loan. However, the fact that the APR equals the interest rate doesn't necessarily mean that you have a no-cost loan because not all settlement costs are included in the APR. You are not paying any of the fees that are included in the APR, but you might still be paying some others.
No-Cost Refinance in Conclusion

The no-cost real estate deposit refinancing is a clear winner for the borrower who intends to sell his house within a few years, and has an existing mortgage with an interest rate above the rate available in the market on a no-cost loan.

During periods of declining interest rates, such as occurred between early 2001 and mid-2004, the no-cost option also works well for borrowers who refinance every time the market drops to a new low. Through successive refinancings, these borrowers keep the life of their loans short. When interest rates start to rise, however, the last no-cost refinancing turns out poorly for those who keep the mortgage for a long period.

In addition, no-cost mortgages are easy to shop, which can result in significantly lower costs. This important point is discussed in No-Cost Mortgages.

Money, Money, Money