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The Imaginary World Of No-Cost Refinancing

You may have heard of no-cost refinancing, as it is an option offered by many lenders. No costs! Sounds great, right?

Not so much.

There is no such thing as a no-cost refinance. It simply doesn’t exist. Never has, never will. 

That being said, not all no-finance mortgage offers are inherently shady. Let’s just say that while they are not a magic way to obtain a loan with zero closing costs, they aren’t necessarily a scam, either. The name is simply dishonest (at the very least.)

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The term “no-cost” would lead one to believe that it is a way to refinance your home without paying anything. This is inaccurate. There are a few different ways lenders go about orchestrating a no-cost refinance, but for the most part, a “no-cost” refinance is nothing more than a “no upfront cost” refinance. Yes, it is a way to get the procedure done without paying anything initially, but you will end up paying for the closing costs one way or another.

This is the case simply because there is no way to close a refinancing without costs involved. There will be both lender and government fees tied in no matter where or when you get your loan. On top of this, your credit needs to be run, paperwork needs to be filled out, checked, and filed, and some sort of legal or certifying entity needs to perform the actual closing. All of those people need to get paid.

Then there are third-party costs, which could include an appraisal, any number of surveys and inspections, and title search and insurance fees. Lastly, you’ll need to set up a new escrow account and insurance either way, as lenders will require two months of each before closing.

Suffice it to say that no mortgage refinancing loan will be free of all of those fees. So, if that’s the case, how are lenders able to offer “no-cost” refinancing? Do they simply cover the costs themselves as a service?

They absolutely do not. Lenders will recoup their money one way or another. There are two common ways they do this.

The first is something that is often referred to as a “no-cash” refinance in the industry. This is where lenders tack all of the closing costs onto the balance of the new loan. This results in you not only paying for the closing costs, but paying interest on them as well. Beware this form of “no-cost” refinancing, as it will almost always result in you paying more than you have to in the end.

The second is where lenders recoup their investment by charging an above-market interest rate. In the decades before mortgage reform, this was done through yield-spread premiums, where the lender paid the mortgage broker or originator for a higher interest rate. Basically, if you qualified for a lower interest rate, the lender would charge a fee to the broker to write the mortgage at a rate higher than you initially qualified for. The higher interest rate would yield more than the fee charged, and the lender kept the rest as their “commission” for the exchange. If it sounds super shady, it’s because it almost always was. Many lenders even used this tactic to collect twice on the closing costs: once by collecting them from the borrower, and again by collecting them from a yield-spread premium.

Recent laws have made it impossible for loan originators to collect compensation from more than one source: they must choose either borrower-paid or lender-paid compensation. A borrower-paid refinancing would be a traditional one, where the closing costs and any points are paid out of the borrower’s pocket. A lender-paid compensation would be an option in the case of a no-cost refinance.

Nowadays, lenders often recover their investment in a no-cost refinance by using a “lender credit.” This is essentially the same thing as a yield-spread premium, except it generally comes in the form of a percentage of the loan amount. And, you guessed it, the lender recovers this fee by charging you, the borrower, a higher interest rate.

Suffice it to say that any “no-cost” option you can find will either come with a higher interest rate, or more interest over time, thus proving that there really is no such thing as a “no-cost” refinance.

Keeping all of that in mind, there are a few instances where this option may make sense.

If you don’t plan to stay in your home for more than a year or two, paying up front in exchange for a lower interest rate is likely moot because you’ll never reap the benefits of the lower interest rate if you’re not in your home long enough to hit the break-even point. If your plans are completely up in the air, it may be a good option in the beginning, but if you do end up staying, you’ll also end up paying.

If simplicity is of higher importance to you than saving money, a no-cost refinance makes sense because it takes away two of the most varying factors: closing cost and loan type. This leaves the interest rate as the only variable, allowing borrowers to shop options with only one aspect to compare side-by-side.

While a “no-cost” refinance is often an attractive option for those who are strapped for cash and can’t pay the closing costs up front, it is highly advised that you at least consider waiting until you can save up the money to cover them. If your situation requires an almost immediate lower monthly payment, and you don’t mind paying more in the end, it probably makes sense to utilize a no-cost option. Just be sure that you won’t regret your decision in the future, at least not too much.

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