Q: We want to refinance our mortgage now that rates have dropped. We see ads for “no cost” refinances, but this seems too good to be true. I remember paying thousands of dollars in closing costs when we got the mortgage to buy our home. Can we really refinance for no cost or is there some kind of catch? – N.T. Lynnwood
A: The only catch is that you would receive a slightly higher interest rate on your new mortgage with a no cost refinance than you would get if you paid the traditional closing costs for a new loan.
Here’s how it works when you get a no-cost loan.
There are a number of different fees that must be paid every time you get a mortgage, whether it’s a purchase loan to buy a home or a refinance to replace an existing mortgage.
These closing costs include fees for the appraisal, title insurance, credit report, escrow service, underwriting fees, processing fees, document preparation fees, etc. Typically, these costs total between $1,500 and $2,000.
In most cases when you refinance a mortgage, the closing costs are added to the balance of the new mortgage. For example, if the balance of the mortgage you were paying off was $200,000 and your closing costs for the refinance were $2,000, the amount of the new mortgage would be $202,000.
This would prevent the borrower from having to pay the closing costs out of pocket. If you were to pay points to buy the interest rate down, those could also be added to the new loan amount, as would the prepaid escrows that you must deposit into an impound account with the new lender to cover your future property tax and home insurance payments.
These numbers add up, and in some cases borrowers end up with a new mortgage that is several thousand dollars larger than the loan they just paid off.
As an alternative, you could opt to keep your new loan amount the same as the mortgage you were paying off. To do that, you would have to pay all the closing costs out of your pocket, or get a no-cost refinance.
Mortgage companies are able to offer no-cost loans by using rebate pricing.
When you apply for a new loan, you can pay points to get a lower interest rate. On a 30-year fixed rate loan, each point (one point equals 1 percent of the loan amount) reduces the interest rate by approximately 0.25 percent.
For example, if you can get a 6.5 percent interest rate for zero points, you could get a 6.25 percent interest rate by paying one point. This also works in reverse. If you accept a higher interest rate, the mortgage company pays points to you, in the form of a rebate.
Continuing with the example above, if a 6.5 percent loan costs zero points, you could get a one-point rebate if you accept an interest rate of 6.75 percent. That means if you have a $200,000 loan, you would get $2,000 (1 percent of $200,000) credited toward your closing costs, which would probably cover all of them. Therefore, you would have a no-cost refinance.
That’s all there is to it. The higher the interest rate, the lower your closing costs. But don’t assume that it’s always smart to go with the lowest closing costs. Higher interest rates naturally mean higher monthly payments. If you plan to keep your loan for a long time (more than five years), it’s probably better to pay the closing costs and maybe even a point or two to get a lower interest rate, because you will save more money in the long run with the lower monthly payments.
On the other hand, if you are not sure how long you will be in your home and you just want to take advantage of lower interest rates for the short term, a no-cost refinance makes sense.
Mail your real estate questions to Steve Tytler, The Herald, P.O. Box 930, Everett, WA 98206. Fax questions to Tytler at 425-339-3435, or e-mail him at economy@heraldnet.com
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