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Mortgage loans & Refinancing: Are "no cost loans" really no cost?

Written by: Joel McDonald

Buyers are often tempted to jump into refinancing their home loan in order to save a half (or quarter) percent on their existing mortgage.  Unfortunately, those "no cost" loans are rarely "no cost".  Here are a few tips to help make sure your loan is a true no cost loan.

Verify how the lender gets paid. 
Nine times out of ten, a no cost loan is structured so that a $200,000 loan is refinanced, and the lender gets their pay by inflating the loan.  After your "no-cost" refinance, it may seem nice because your payment is $40 or $50 a month cheaper, however, instead of only having 25 years before your loan is paid off, you now are going to take 30 years to pay it off because of the refinance.  Not only have you "reset" your amortization schedule, but you now owe $203,000 on the loan you only owed $200,000 on prior to the refinance.  Although your monthly payment is lower, and you didn't pay any money out of pocket (yet) for the loan, it isn't really a no cost loan. When you go to sell your home you'll now owe $3000 more than you would have had you not refinanced.

Make sure your loan officer gets paid via the yield spread.
In order to make sure your loan officer gets paid via the yield spread vs. out of your pocket, or by inflating the mortgage loan, ask your loan officer the following question:  "If we go through with this refinance, can you please make sure that my loan's principal balance isn't a penny more than what it is now, and also make sure that I don't pay a penny out of my pocket?" 

By asking that exact question, you will force your loan officer to make sure they get paid by inflating your interest rate high enough that they get paid via "yield spread" from the loan institution who funds the loan.  If they can't get you such a loan, it is NOT worth refinancing your loan.  (For example, if you refinanced a $200,000 loan, you have 3 choices:

(1)Pay about $2000 out of pocket as an "origination fee" to your loan officer and get a 5.5% interest rate.

(2) Pay nothing out of pocket, but get a new loan at $202,000 - $2000 of which will go toward paying your loan officer's origination fee. (This will also get a 5.5% interest rate)

(3) Refinance your loan at $200,000, pay nothing out of pocket, but take a 5.875% or 6% interest rate.  Yes, you'll have a higher interest rate, but this is the only true "no cost" option.  If the interest rate you are given is not better than your existing loan rate, you should NOT refinance your loan.

In a nutshell, option 3 is the only option where your loan officer gets paid without it costing you money out of pocket.  If there is a chance you will sell your home within the next couple or few years, you should never refinance with any other option than #3.  If you think you will own the home longer than 3 years, options 1 or 2 might be worth your while.

About the Author

Joel McDonald is the founder of Make-Them-Pay.com - a website dedicated to empowering home buyers to get the most out of their real estate agents.

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