You may hear lenders advertise or suggest a no-cost refinance. You probably wonder how that could be possible. What lender would offer a refinance without charging anything? Closing costs can be in the thousands of dollars, so what’s the catch?
The truth is that there is a catch. You won’t get the loan for ‘free.’ You’ll just pay it in other ways.
What the No-Cost Refinance Means
When a lender offers a no-cost refinance, it means that they will refinance your loan without charging you any closing costs upfront. It doesn’t mean that they won’t charge you for them, though. Typically, they get the payment from the higher interest rate that they charge you.
Let’s say that a lender offers you two options:
- Option A is for a $200,000 loan at 4.5% with $3,000 in closing costs
- Option B is for a $200,000 loan at 5% with no closing costs
Do you see the difference? You pay a higher interest rate so that you don’t have to come up with any money at the closing. The lender eats the costs of processing the loan while collecting more interest on your loan than they would have if they charged the closing costs upfront.
What’s in it for the Lender?
You probably wonder why a lender would even consider this option. Don’t they need the money upfront? While they do, they actually make out on the deal if you end up keeping your loan for the entire term. When you pay a higher interest rate, you pay it for the life of the loan.
Let’s say that Option B was for a 30-year term. You would pay $61 more per month with the higher interest rate. That’ doesn’t seem like a lot, but let’s look at it over the life of the loan. $61 per month is $732 per year and $21,960 over the life of the loan.
That means the lender comes out ahead $18,960 by giving you the higher interest rate rather than collecting the closing fees from you.
Now that’s only if you keep the loan for the entire term. That’s the lender’s hope and why they would give you the no-cost refinance.
Do you Benefit?
You may benefit from the no-cost loan in a couple of ways. First, if you truly don’t have the money to pay for the closing costs now, you may have no choice. If the refinance is vital for you, because it will save you money on your loan each month, it may make sense to do so.
You may also benefit from the no-cost loan if you know you will move in the near future. Let’s say that you know you’ll move in three years, but you want to refinance because you have a high payment right now. If taking the slightly higher interest rate of the no-cost loan still benefits you, take it. This way you save money on your monthly payment and you get away with paying the closing costs.
In our above example, as long as you move before you have the refinanced loan for 4 years, you make out on the deal. Obviously, the earlier that you move and pay off the loan, the more you come out ahead, but the point is that you didn’t have to pay the closing costs on a loan that you knew you would not have for long.
Basically, you need to know where you break-even. When will the extra interest you pay for the no-closing cost loan cover the closing costs? If you will be in the home much longer than that break-even point, paying the closing costs yourself makes more sense. Otherwise, you’ll end up paying excessive interest and not benefiting from the deal. Ask your lender for quotes for both options and then see which way you come out ahead in order to make your decision.