No-Cost Loans Offset by Higher Rates

Question: Are “no-cost” mortgages are a bad deal for borrowers?

Answer: Borrowers usually pay too much for “no-cost” loans, which are poorly priced for cash-short borrowers. Borrowers also don’t know how to shop for them.

Borrowers pay for a “no-cost’ loan by accepting a higher interest rate than they would if they paid points. Points are upfront fees. Each point is 1% of the loan amount.

Lenders typically offer different combinations of interest rate and points. The higher the rate, the lower the points. If the rate is high enough, points are negative; that is, the lender credits them to the settlement costs. This is how “no-cost” mortgages are created.

To illustrate, I recently shopped eight lenders online for 30-year fixed-rate loans in California. The loans had rates of 7.5%, 8.25% and 9%. All the loans were for single-family homes for permanent occupancy, and carried 30-day locks.

On average, these lenders offered 7.5% at 3.25 points, 8.25% at zero points, and 9% at -2.25 points. If settlement costs amounted to 2.25 points or less, the 9% rate could be the cost of a no-cost loan.

Borrowers elect no-cost loans for two reasons: They are either short of cash, or they don’t expect to have the mortgage very long. Borrowers in the second group minimize their upfront costs because they expect to pay the high rate for a short period.

Because high-rate mortgages have a relatively short life, lenders price them accordingly. Note that increasing the rate from 7.5% to 8.25% results in a 3.25 point reduction, but increasing the rate from 8.25% to 9% results in only a 2.25 point reduction.

The cash-short borrower who does not expect to move within a few years thus pays a stiff price for a no-cost mortgage.

No-cost loans are also a bad deal for borrowers because they often leave money on the table. Suppose the rate for a no-cost loan is 9%, based on negative 2.25 points. On a $100,000 loan, the value of the negative points is $2,250. But if actual settlement costs are only $1,800, the borrower pays $450 too much.

Borrowers offered no-cost rates by loan officers never get to see the negative point values. They don’t show up in print ads, and loan officers don’t discuss them.

The usual practice is to select a no-cost rate where the value of the negative points more than cover settlement costs. The difference, called an “overage,” is retained by the lender or mortgage broker, and usually shared with the loan officer.

Overages can also arise on positive point loans, when the loan officer collects points in excess of the points shown on the price sheets given to them by the lender or mortgage broker.

But a study I conducted several years ago revealed that overages are heavily concentrated in negative-point loans. I suspect that borrowers who need no-cost mortgages don’t comparison shop very much. In the absence of information on negative points, shopping wouldn’t accomplish much.

But the Internet has begun to change this. A number of mortgage Web sites allow consumers to see negative points quotes. The sites refer to them as “rebates.” I particularly like Iown.com (https://www.iown.com), one of the multi-lender shopping sites.

Other Web sites allowing borrowers to select rate/point combinations that include negative points include HomeAdvisor.com, (https://homeadvisor.msn.com/ns/), KeystrokeNet.com (https://www.eystrokenet.com/) and HomeSpace.com. (https://www.homespace.com).