Why in the world would anyone want to pay $10,000 to refinance; especially when there are all kinds of lenders advertising “free” loans? Well, because the idea of a “free loan” is a little misleading and lenders use this to their advantage when advertising these programs. If the idea of paying closing costs makes you cringe, you need to read this.

No Such Thing As A Free Lunch

Ever heard the saying, “There’s no such thing as a free lunch?” Well there’s no such thing as a free mortgage either; think about it, there’s a lot of work that brokers and banks put in to helping you refinance. Do you think these people are working for free? They’re definitely not. So, what is a “free loan” really and how does it differ from a loan with closing costs?

pay points to refinanceScenario 1: Let me give you a little info on how I price a loan with a lender to help you understand this. Lenders allow borrowers to pay points upfront in exchange for a lower interest rate; the opposite holds true as well: lenders will pay a rebate in exchange for a higher interest rate. So, let’s say you want to refinance your house and you’re willing to buy the rate to the “floor” (the lowest rate the lender has available); such a refinance can cost a lot of money upfront. As of today, for example, a borrower with a loan amount of $600,000 can get an interest rate of 5.75% at a cost of 1.6 points, or about $9,600 – not including other closing costs, which can run another $9,500. As I write this I can just picture you shaking your head saying, “There’s no way I would pay almost $20,000 to refinance my house!” No problem, let’s see what kind of rate we can get “for free”.

Scenario 2: As of today (remember, rates change every day), that same borrower can get a loan with absolutely no closing costs at a rate of about 6.75%. How are there no closing costs? Because in exchange for accepting a higher interest rate, the lender will pay a rebate of about 1.5 points (1.5% of the loan amount), or $9,000. That $9,000 will go to pay for your closing costs so you don’t have to.

The Free Loan Myth

So, the question is, “Is the loan really free?” Well I’ve already told you no, but let me prove it to you.

In scenario 1 above, your monthly payments would be around $3,600 a month. Scenario 2 would give you payments of around $3,900 a month because of the higher interest rate. So, why would anyone pay $20,000 to save $300 a month? When the cost of the buy-down pays for itself before you refinance again. If you take the cost of the buy-down, $20,000, and divide by the monthly savings of $300, you find that it will take about 67 months (5 years, 7 months) to break even. Obviously if you’re only going to be in the house for another 3 years, the buy-down isn’t worth the cost, but what if you are refinancing into a 30 year fixed and don’t have any plans to move in the future? In this case, the buy-down saves you $88,000 over the life of the loan and gives you a lower monthly payment.

So, next time you see one of those TV commercials advertising a no closing cost loan, remember, there’s no such thing as a free lunch. A good mortgage broker will be able to calculate the best option for you based on your goals.

Categories: Mortgage


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