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

A no-cost mortgage is one where the lender charges a higher interest rate in exchange for paying most of the borrower’s settlement costs.

In last week’s column I gave two reasons, in addition to being short on cash, why a borrower might find a no-cost mortgage advantageous. One is that the borrower does not expect to have the mortgage very long, in which case he won’t be paying the higher rate very long. A second reason is that the no-cost mortgage provides protection against being overcharged at the settlement table.

Why no-cost mortgages protect against being overcharged: In selecting a loan provider, borrowers typically shop for rate and points, ignoring other settlement costs. They usually find out about these costs after they submit an application, and then they receive “estimates” that are subject to change. This provides lenders with ample opportunities to pad their own fees and mark up those of third parties.

When responding to a borrower inquiring about a no-cost loan, however, lenders do not have that luxury. A borrower shopping for a no-cost loan has only one price to consider – the interest rate – and lenders have to assume that they are being rate-shopped. The rates they quote, therefore, are likely to cover their true costs, which could be well below the costs faced by borrowers who don’t go the no-cost route.

No-cost loans can limit broker fees. On no-cost loans that go through brokers, the broker’s fee is an additional cost that must be covered by the rate. This can limit broker fees because lenders cap the rebates they are prepared to offer for higher interest rates.

A recent study of brokered loans by Susan Woodward showed that total settlement costs including broker fees were $1,500 lower on no-cost than on other loans. While no breakdowns were available, it is likely that most, if not all, of the $1,500 was lower broker fees.

A no-cost shopping strategy, focusing entirely on the interest rate, works best for a refinancing borrower with a short time horizon. Virtually all lenders offer no-cost refinancing if borrowers request it. Borrowers can shop brokers and lenders interchangeably. They need not concern themselves with brokers’ fees because the fees are covered by the rate.

Refinancing borrowers with long time horizons can buy down the rate by paying points while the lender pays the costs. Decide the rate you want to pay, then shop for the lowest points on a loan that is no-cost (except for points). This is a “semi-no-cost mortgage.” For example, you ask the loan provider, “How many points for a 6 percent, no-cost 30-year mortgage?” This is easier than setting a certain number of points and shopping for the lowest rate because most lenders quote rates in even 1/8 percent increments, whereas points can be odd decimals.

Be prepared for some funny stares, to be told that it can’t be no-cost if your are paying points, and to be asked why you would rather pay points than costs. Here is your answer:

“I want to pay points and have the lender pay other settlement costs because I can lock the points with the rate, but I can’t lock the other settlement costs.”

Warning: Do not shop for the lowest no-cost quote, select the loan provider, and then negotiate a buy-down. The negotiation could cost you everything you gained in the shopping process.

No-cost mortgage shoppers should be wary of “sunshine blowers.” These are loan providers who quote rates they have no intention of honoring. Because the market changes daily, no loan provider can be held to a rate quote except on the day the loan is locked. The sunshine blowers use market volatility as an excuse to raise their low-ball rate when it comes time to lock the loan.

For example, he quotes 6 percent to the borrower when most other lenders are quoting 6.125 percent. A week later when the borrower is ready to lock, the sunshine blower quotes 6.375 percent, but other lenders are quoting 6.25 percent.

One way to protect against this is by shopping only lenders who have Web sites that show the borrower’s price day by day. Another way is to shop Upfront Mortgage Brokers (UMBs) who will show the borrower the relevant price on the wholesale price sheet. UMBs are listed on my site.

When the borrower is purchasing a house rather than refinancing, using no-cost mortgages as a shopping tool is a little more challenging. This will be discussed 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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