No Closing Cost Refinances and Purchases

Any loan where the broker or lender pays all of your closing costs is commonly referred to as a "no closing cost" loan. These closing costs would include title & escrow fees, appraisal, lender's fees, credit report fees, and other expenses which are non-recurring over the life of the loan. Lenders use the term non-recurring to refer to only those expenses which are one time, and to exclude items such as interest, insurance, and property taxes, which are considered recurring closing costs because they will continue to be expenses every month. Recurring costs are not covered expenses in a "no closing cost" loan.

In the mortgage market, there are a variety of interest rate and point combinations available to the borrower at any point in time for the same product or loan type. As an example, for a loan amount of $200,000 a borrower can be quoted 6.75% with .875% points, 7.0% with zero points, or 7.25% with "no closing costs". All three of these quotes are for a 30 year fixed-rate mortgage. The lender allows the borrower to choose their own rate and point combinations since some people prefer a lower rate immediately, while others prefer minimizing how much they pay out of pocket up-front. Thus, the borrower can select the combination which feels most comfortable to their personal situation. For some borrowers, the "no closing cost" option of 7.25%, while providing a slightly higher rate, still requires the least investment up-front and therefore is the best option.

A true "no closing cost" loan differs from both a "no lender fee" loan or a loan in which the lender adds the closing costs to the amount financed. A "no lender fee" loan, sometimes advertised by banks, usually will not cover the title, escrow, and other outside charges you may need to complete the refinance or purchase.

"No-cost" loans will always carry a slightly higher rate than a loan that does not pay your costs. In general, a "no-cost" loan is the better strategy if you plan to keep your loan for the next one to three years. Longer than that, you should consider paying the costs yourself to get a lower rate since over time the lower interest rate will save you more money. And if you plan to keep the loan for four to five years, it often makes sense to pay closing costs and points to get an even lower interest rate. (Points are up-front mortgage interest fees paid on a loan to reduce the initial interest rate.)

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No-Cost Refinances

"No closing cost" loans can be used for either a refinance or a purchase transaction, although they are most commonly associated with a refinance. A "no-cost" refinance is the quickest way to generate immediate interest rate and payment savings with no up-front investment in closing costs. Let's assume that a borrower is currently at 7.5% on a 30 year fixed-rate loan and is interested in refinancing now that interest rates are declining. But what is the best time to finally "bite the bullet" and lock in a rate? If the person chooses to refinance using the "no closing cost" method, it doesn't matter when they lock in, so long as they are immediately saving money by refinancing. By choosing the 7.25% "no closing cost" loan, their payment would decrease right away, with no up-front investment to refinance. Should interest rates continue to decline, the borrower can simply refinance again to obtain additional savings.

With a true "no closing cost" loan, you can refinance for any incremental drop in your interest rate. Because there is absolutely no investment in up-front costs, the savings of refinancing are immediate. In a market where you believe interest rates may continue to fall, it makes sense to refinance at no cost. Should interest rates decline further, you can refinance again without having to recoup the closing costs. Many borrowers refinance every year or less at no cost, while keeping their initial teaser rate in an Adjustable Rate Mortgage.

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Tax Issues - Refinance

A "no closing cost" loan will not have points, and thus no deduction for that cost. But the loss is trivial. In a refinance transaction, points must be amortized over the life of the loan. For example, on a 30 year loan, you can deduct 1/30th of the points paid each year. If you refinance for a second time, however, you can deduct the remaining un-amortized points in the year you refinance the loan. Consult your tax advisor for more information.

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No-Cost Purchases

In a purchase situation a "no closing cost" option can work extremely well when the borrower has limited funds available for closing or when the interest rate market is declining and the borrower may want to refinance quickly. "No closing cost" loans can be used effectively to free up more cash for the down payment or save for repairs or other uses. If the seller can not credit for closing costs (due to low equity or other reasons), a "no closing cost" loan is the next best alternative.

In some cases, "no closing cost" loans can give a borrower more cash than is needed for the direct closing costs. As long as this does not exceed the lender's guidelines (typically 3% of the purchase price in overall credits), this cash can be applied to other costs in the transaction.

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Tax Issues - Purchases

While most people associate a purchase with paying points just to obtain tax deductibility of the points, this is too simplistic a view. While the tax deductibility is an important factor, it is only one consideration for a borrower. Paying points up-front to secure a low rate, in a steadily declining interest rate market, may be simply throwing money away. If the borrower decides to refinance shortly after a purchase, the points and costs paid up-front will be a wasted expense.

A "no closing cost" loan will not have points, and thus no deduction for that cost. Additionally, the other costs are paid for and no deduction is available. If you are purchasing a home, points and some costs are generally entirely deductible in the year you buy.

In summary, "no closing cost" loans can be used successfully in either a refinance or a purchase loan. These loans will minimize the up-front closing costs that you pay, and are generally best used in a stable or declining interest rate environment. By carefully using this type of strategy, a borrower can continue to replace his home loan without incurring costs or increasing the outstanding principal balance of the mortgage. Consult your tax advisor for more information.

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