Refinance with No Closing Costs

Is there really such a thing as a refinance with no closing costs?

1 Answer

If it looks too good to be true, it probably is. Let me explain... Even if we omit the lender's fees that get charged in connection with a mortgage, there are still third party fees, e.g., title examination and insurance, closing fee, recording fee, flood determination, appraisal etc. None of these parties give away their time, resources or services for free, nor does the mortgage broker or the retail lender who arranges your loan for you. The money to pay these people has to come from somewhere.

Here's how it works. Banks and mortgage companies make lots and lots of loans. They pool them together and use them as collateral for loans that they get from institutional investors. This process is referred to as " securitization." The loans they get are in the form of bonds that they sell in the financial markets, i.e., Wall Street. When the institutional investors like hedge funds, pension funds, insurance companies etc. buy these bonds, they expect a certain return on their investment. This rate of return is referred to as the bonds' yield. This describes the rate of interest that the investors earn from these bonds.

Let's say, for example, that on a given day because of supply and demand, bonds that generate a 6% yield sells for $100,000 dollars. If on that day a mortgage company came to the market with bonds backed by loans that generated 8% interest, those bonds would sell for more than $100,000, maybe $104,000 or $105,000. In the financial markets, they say that those bonds sell for a "premium" over the market price. Bottom line: when the investors on Wall Street expect to make a yield of 6% and a bond with a face value of $100,000 generates interest of more than 6%, those investors pay more than $100,000. This is how banks and mortgage companies make their profit. By issuing bonds (i.e. borrowing money) that pay a given rate and issuing mortgages (i.e. lending money) at a higher rate, they earn a profit. Thus, the bigger the difference between the rate at which they borrow and the rate at which they lend, the more they get paid.

So, if a lender figures that on a given day, they can borrow money at 6%, lend it at 7% and cover their overhead and make a reasonable profit, the rate you will see advertised in the paper will be 7%. If they have to pay your closing costs they have to charge a higher rate if they still want to be able to cover their overhead and generate money for their shareholders. By charging a higher rate, they get paid more for the pools of loans that get turned into bonds. That extra money is used to pay your closing costs when you get one of those "no closing cost" loans.

All of that being said, the important thing to know is not whether there really is such a thing as a " no closing cost loan" -- because in reality, there isn't -- but rather whether what gets referred to as a "no closing cost loan" makes sense in your particular situation. For instance, let's say currently have a loan that has a rate of 8% and you have a choice of refinancing into a loan with closing costs that carries a rate of 6% and one that has no closing costs and a rate of 6.5%. Assume that the difference between the monthly payments is $100 and that for the loan with the lower payment the closing costs add up to $5000. By paying closing costs, you save a hundred dollars for every month that you keep the loan past month number fifty. On the other hand, if you plan on keeping the loan for less than 50 months, it doesn't make sense to pay the closing costs because the total monthly savings don't cover them.

Before we finish, let me make it clear that the numbers used in my example are for illustrative purposes only. When you are out shopping for a loan, you should consult with an experienced and knowledgeable mortgage professional. Ask that person to give you a "break-even" analysis so you can determine whether paying closing costs or going with a "no closing cost loan" makes more financial sense for your particular situation.