The current refinance boom has focused attention on no-cost mortgages — henceforth NCMs — which have attractive features to refinancing borrowers. NCMs help borrowers avoid being overcharged, and they eliminate most of the uncertainty involved in determining whether a refinance will pay.
On the other hand, the price of NCMs — as measured by the interest-rate increase borrowers must pay to avoid refinance costs — is unusually high in the current market. The challenge is to obtain the benefits of NCMs without paying an excessive price for them.
An NCM is a mortgage on which the lender pays the borrower’s settlement costs, with certain exceptions. The lender won’t pay your tax escrows, homeowner’s insurance or transaction taxes if there are any. You will also be stuck with paying interest on two loans for a few overlapping days. 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. No-cash means the settlement costs are added to your loan balance at closing. The borrower pays them, but over time and with interest.
NCMs help borrowers avoid being overcharged by reducing multiple price dimensions to one: the interest rate. Typically, in selecting a loan provider, borrowers 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 an NCM, however, lenders do not have that luxury because the borrower is shopping strictly for rate. The rate lenders quote on an NCM, therefore, is likely to cover their true costs rather than a padded cost.
Borrowers shopping for an NCM can shop brokers and lenders interchangeably. Brokers must include their own fee in the quoted interest rate, which they know is being shopped. This imposes a competitive constraint on broker fees.
NCMs also eliminate most of the uncertainty involved in determining whether a refinance will pay. If there are refinance costs, the borrower must decide whether the costs are offset by the lower rate. I send readers faced with this puzzle to calculator 3a on my Web site. But if there are no costs, you don’t need a calculator because any rate reduction is a winner.
The rate quoted by a lender on an NCM is one that, from the lender’s standpoint, justifies paying the costs. The lender willing to accept a rate of X percent on a loan where the borrower pays the costs, will quote X + I on an NCM, where I is the rate increment needed to cover the cost.
Unfortunately, in the current market I is more than twice as large as it was only a year ago. The reason is that lenders are assuming they won’t have the rate increment very long because market rates will decline further and many of the loans refinanced today will be refinanced again in the near future. This is the same reason why, as I indicated in an article a few weeks ago, the best bargain in today’s market is buying down the interest rate by paying points.
The upshot is that borrowers refinancing today, unless they expect to move within a few years, should pay their own settlement costs and, if they have the cash, pay points to reduce the rate. To do this, while retaining the strategic benefit of shopping for an NCM, follow these steps:
1. Shop for the best rate for an NCM.
2. Shop for the lowest points, but otherwise no-cost, at a specified rate.
For example, assume three NCM quotes come in at 5.5 percent, 5.625 percent and 5.75 percent. Ask all three how many points you would have to pay to reduce the rate to, say, 5.25 percent, emphasizing that the loan otherwise remains no-cost. You are now shopping for a modified NCM on which the borrower pays the points required by a specified rate, but the lender pays all other settlement costs.
In the example, you select the lender quoting the lowest points for the 5.25 percent rate. Do not select the loan provider quoting the lowest rate on the NCM, and subsequently ask about buying down the rate. The loan provider who has already been selected may well give you a much less advantageous quote than one who is competing to earn your business.
Consider rolling your own NCM with an Upfront Mortgage Lender (UML). UMLs are Internet-based lenders who display all prices and fees on their Web sites, which makes it simple to find the rate that will cover your costs. And if you have a long time horizon and the cash to buy down the rate, you can do it without fear that the settlement costs will escalate on you.
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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