The no closing costs mortgage sounds like a good deal initially. Who would not want a loan without fees? But how can any mortgage company offer you a loan without charging you the fees it normally charges?

It can do so by charging you more interest each month than you would normally pay. The lender raises the interest rate on your new loan, and some borrowers are willing to pay a higher rate in exchange for low or no fees upfront.

The question is should you be willing to pay a higher rate in exchange for that “no cost” loan? The mortgage company will often charge 0.25% - 0.50% more on your rate to reduce your fees to zero.

That would translate to approximately $98 more each month on a $300,000 loan. When is it worth it to spend that extra $98 per month to avoid paying the closing fees when you get your new loan? If you are reducing your initial closing costs by $5,000, most people would guess five years. Five years of $98 per month payments nearly equals the $5,000 you would save in start up fees.

But you would be wrong because it is not that simple. Your mortgage balance on the lower rate mortgage will be quite a bit lower than the higher rate loan would be five years down the road.

You must consider the difference in monthly payments and the difference in mortgage balances when you sell your home in order to make an accurate calculation. If you intended to sell your home in five years and chose the higher rate no cost loan because you thought five years was the break even point, you would have cheated yourself out of about $2,500.

The true break even point is slightly more than three years. After that, the lower rate and higher fee mortgage will be the better bargain.

Some people will take the comparison even further by adding inflation, your income tax rate and the rate of return on your investments to the mix. The problem with that is that you are then dealing with unknowns. You do not know what the rate of inflation will be for the next five years. You can only guess. If you guess wrong, all of your calculations are also wrong.

Inflation has been stubbornly low in recent years and promises to remain low unless macroeconomic trends change.

Your income and your tax rate may also change in the future. Many people use an across the board tax rate of 28% - 35% in such calculations, but the tax savings are rarely that much. In addition, you do not know what changes the IRS will make to tax return calculations that may or may not influence the numbers.

Your future rate of return on your savings is probably the most elusive number to calculate. The numbers that some so called experts use here are often highly optimistic.

The real question in that regard is will you actually invest the monthly savings or will you simply spend the $98 you would have saved on something else? Would you really have invested that $5,000 in closing costs or would you have used it to buy a big screen TV?

Throwing too many numbers into the mix like some so-called mortgage “professor” types do only serves to confuse the general public. There is a common expression of “garbage in and garbage out” that computer experts use when valuing calculations.

Throwing in too much garbage will only stink up your results, and that is also true with “no cost” mortgage calculations. You are usually safe in using a three year time frame. If you intend to keep your home and mortgage for less than three years, then the no cost loan is a viable alternative. However, if you expect to be in your home for more than three years, you are usually money ahead by paying the normal fees and opting for the lower rate.

Bob Roscoe, Mortgage Marketing Associates, Minneapolis, Minnesota

More on No Cost Mortgages…

Have you ever seen an ad for a mortgage with no closing costs? This type of ad is more prevalent than it used to be, and it is because traditional mortgage business has slowed in recent years.

What do companies do when new business gets scarce? They will often drop prices to attract more customers. A no closing cost mortgage sounds like the mortgage company is offering to charge you no fees to write a new mortgage, but, of course, it isn’t.

What it is really doing is raising the interest rate that it charges you on your new mortgage to pay for that “no cost” loan. The mortgage company then uses the additional interest it earns from the higher monthly payments that you are making on your new mortgage to pay for the costs it incurs to write that loan.

The mortgage lender tells you there are no costs to your new mortgage, and some of you actually believe it.

In Minnesota the fees charged by the government agencies on a new $300,000 are about $787, and there is legislation currently being considered by the state legislature to raise those fees considerably–to over $1,000. On a no cost mortgage, is the government willing to let you get by without paying that $787 fee that it normally receives?

No, of course not. That $787 still gets paid on a no cost mortgage.

The appraiser will often charge a fee of $325-350 or more to perform an appraisal on a traditional mortgage transaction. Is the appraiser willing to accept no fee for doing his work? Of course not; he still gets paid.

All of the other fees that are normally charged in a traditional mortgage transaction are still charged and paid on a “no cost” mortgage. The credit reporting agency still gets its fee for providing your credit report. The title insurance company still receives its fees for providing a title policy and closing the loan.

No one is willing to work for free. You are the one who is paying for that “no cost” mortgage, and you are paying for it by paying an above market interest rate on your new mortgage.

Next time we will explore how that higher rate mortgage pays for those fees you seem to think you are not paying on your “no cost” mortgage.

Bob Roscoe, Mortgage Marketing Associates, Minneapolis, Minnesota

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