Thursday, June 27, 2013

The Cost of a “No Closing Costs” Mortgage

About five years ago I worked for a title company in Wisconsin and frequently closed residential real estate mortgage transactions.  This included both new loans for home purchases and the refinancing of existing loans.  Often times the borrowers would get what was referred to as a “No Closing Costs” loan.  This article will explain the cost of a “No Closing Costs” mortgage loan at that time.  Additionally, I hope that in the comments readers will let me know if this is still how it works in the mortgage industry.   

Virtually every mortgage comes with closing costs, and these costs are typically well over a thousand dollars for mortgages over $100,000.00.  Let’s say there is $1,200 in closing costs for a $130,000 mortgage loan.  How does the mortgage broker pay this extra $1,200 and still make money?  The mortgage broker offers the borrower a mortgage with a high enough interest rate that allows the bank to pay the mortgage broker an amount that will compensate the broker for his services and for the paying the closing costs.  In other words, the higher interest rate pays for the closing costs.

Have you ever wondered how a mortgage broker gets paid for his or her services?  Theoretically mortgage brokers could get paid directly by the borrower, but I have never seen that happen.  Typically, the bank pays the mortgage broker.  The amount of this payment is referred to as the yield spread premium.  The amount of yield spread premium that banks are willing to pay to a broker rises with the interest rate that is being considered.  In other words, everything else being equal the bank will pay the broker a higher yield spread premium for a loan with a 4% interest rate than a loan for a 3% interest rate.  

Consider the following rate sheet that I used to use to explain this concept to people.  You can certainly tell it is old given the interest rates:

Interest Rate %
Yield Spread Premium, i.e. Commission % of Loan Amount
What the Broker would make on a $130,000 loan

        Using this rate sheet, if the Broker were to offer the Borrower a mortgage under which the Broker pays the closing costs he might offer the Borrower an interest rate of 6.125% and pay the borrowers closing costs. This would mean the Broker would receive $3,224 from the bank, and then credit the borrower $1,200 for the closing costs. The Broker would still make $2,024 or 1.56% of the loan ($3,224-$1,200=$2,024).  So did Broker pay the closing costs? Yes and no. The borrower could have paid his own closing costs and got a mortgage with an interest rate of 5.75% and the broker would have made $2,086.50. So effectively the borrower paid his own closing costs by accepting a higher interest rate.

        Let’s examine the effect of this further. Using a mortgage calculator on lets consider the difference in payments under the following mortgages:

Mortgage 1:
Mortgage Amount: $130,000.00
Mortgage Term: 30 years
Interest Rate: 6.125%
Monthly Payment: $789.89

Mortgage 2:
Mortgage Amount: $130,000.00
Mortgage Term: 30 years
Interest Rate: 5.75%
Monthly Payment: $758.64

Difference between Mortgage 1 and Mortgage 2:
Monthly Payment Difference: $31.25
Yearly Payment Difference: $375
Difference over 30 years:   $11,250

So over the course of 30 years, the borrower will pay $11,250 in interest for their closing costs.  Does that sound free to you?  Of course this does not mean that you should not accept a “No Closing Costs” loan.  Most people do not keep the same mortgage for 30 years because they either refinance their mortgage or sell their home before the 30 years is up.  Consider the following:

Difference between Mortgage 1 and Mortgage 2:
Difference after 2 year: $750
Difference after 3 year: $1,125
Difference after 4 year: $1,500
Difference after 5 year: $1,875
Difference after 10 years: $3,750
Difference after 15 years: $5,625
Difference after 20 years: $7,500
Difference after 25 years: $9,375

From this additional information we can see somewhere after 3 years but before 4 years the difference in the payments exceeds the $1,200.00 that the broker paid for the closing costs.  In other words, if you sold your home before that point in time the “No Closing Costs” loan was a better deal than the loan with a lower interest rate where you paid your own closing costs.  This point would be even further into the life of the mortgage if you considered the time value of money—money today is more valuable than money tomorrow.

 Evaluating the price of a mortgage can be a complicated task.  There are numerous price variables that need to be considered when deciding whether a particular mortgage is a good deal. Price variables include, but are not limited to, the interest rate, fees, points, closing costs, penalties, private mortgage insurance, required escrow accounts, etc.  Each time one of the price variables is adjusted it can make the mortgage more or less expensive to the borrower.  A conversation I once overheard between a mortgage broker and his customer nicely demonstrates this concept:

Broker: “Right now I can get you a 30-year mortgage loan for $100,000.00 with a fixed interest rate of 0%.” 
Customer: “Really? How can you do that?”
Broker: “Simple. You will have $100,000 in closing costs.”

There is nothing earth shattering about the idea that businesses will often raise prices before giving a discount.  However, examining the cost of a “no closing costs” loan is an interesting example of that practice because if you get a hold of the banks wholesale rate sheets—and some Banks make them publically available on the internet—then you can see exactly how the shifting of costs occurs.


© June 2013 Brandon J. Evans