(This is Part 1 of a three-part series. See Part 2: Why select a no-cost mortgage? and Part 3: Lenders roll out no-cost-mortgage deals.)

“Why wouldn’t anyone in his/her right mind take a no-cost mortgage if he/she could find one?”

Because no-cost mortgages don’t eliminate costs, they convert them from costs paid upfront to costs paid over time. No-cost mortgages carry higher interest rates, which may be better for some borrowers, but not for others.

“No-cost mortgage” defined. A no-cost mortgage is one on which the lender pays the borrower’s settlement costs, with the following exceptions:

  • Per-diem interest, which is interest from the closing date to the first day of the following month, isn’t included because it is not known until the exact closing date is set.

  • Escrows for taxes and insurance, which are borrower funds set aside to assure payment of the borrower’s future obligations, are not covered because they are not a cost of the transaction.

  • Homeowners’ insurance is not covered because, while required by the lender, it also benefits the borrower. Owner’s title insurance is not covered because it is optional or paid by the seller.

  • Transfer taxes, if any, are not covered because the amount is sometimes uncertain, and it is set by a governmental entity.

All other costs, including the mortgage broker’s fee if there is one, are paid by the lender.

Don’t confuse no-cost with no-cash. This is one of the worst mistakes a borrower can make. “No-cash” means the borrower does not have to pay the settlement costs at closing, but the lender doesn’t pay them either. The costs are added to the loan balance, so the borrower pays them over time, with interest.

Borrowers pay a higher interest rate on a no-cost mortgage. The lender finds that rate by estimating the costs for which he would be responsible, and then finding the interest rate that justifies paying those costs.

For example, Doe is borrowing $200,000 on a 30-year fixed-rate loan. The lender’s price schedule on this loan includes the following quotes: 6.25 percent with zero points, 6 percent with 1.5 points, and 6.75 percent with a 2.125-point rebate. Points are upfront payments – one point is 1 percent of the loan amount. Borrowers pay points to the lender, but lenders credit borrowers for rebates.

Assume Doe wants a no-cost loan. The lender calculates that it would cost $4,000 to assume responsibility for the settlement costs Doe would otherwise pay. He thus charges Doe 6.75 percent for a no-cost loan. The rebate of 2.125 points at 6.75 percent is $4,250 on a $200,000 loan, or enough to cover the $4,000.

No-cost loans are least profitable to borrowers with long time horizons. The benefit of the no-cost loan is the saving in cash outlay at the outset, while the cost is the higher rate. The longer the borrower has the mortgage, the higher the cost. A borrower with a long time horizon who takes a no-cost mortgage only to save cash gets a bad deal.

A long horizon is one that exceeds the break-even period (BEP). The BEP is the period during which the cost of the higher rate just equals the benefit of having lower upfront costs. Over periods shorter than the BEP, the no-cost loan has lower costs. Beyond the BEP, the no-cost loan has higher costs. No-cost loans are more advantageous the longer the BEP.

I have two BEP calculators on my Web site, 11a for fixed-rate loans and 11b for adjustables. The calculators factor in the tax benefits on interest and on points, the reduction in loan balance, and interest loss on monies used to make monthly payments and pay points that could have been invested.

The BEP for Doe in selecting 6.75 percent with a 2.125 point rebate rather than 6.25 percent at zero points is somewhere between 4.5 and 8 years. The exact BEP depends on Doe’s tax bracket, and on the return he could earn on investments.

The BEP is longer if the lender marks up the costs charged borrowers who pay the costs but not the costs used in setting the no-cost rate. The lender in the example assumed that he would have to pay $4,000 in costs on the 6.75 percent no-cost loan. The calculated BEP assumes that Doe would pay $4,000 in settlement costs on the 6.25 percent loan. However, if the lender would charge Doe $6,000 when Doe pays his own settlement costs, the BEP rises to 6-11 years. In effect, the no-cost loan allows Doe to avoid being overcharged.

In fact, retail lenders dealing directly with borrowers do sometimes charge fees above the cost of providing services – when they can. Wholesale lenders don’t because their fees are scrutinized by brokers. I discuss this further in next week’s column.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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