Ring, ring, ring. Since interest rates are at their best levels in two years, I am thinking about refinancing with a “no closing cost loan”. I have disbelief, though, when someone says there are no costs. I sense I must be paying these costs somewhere. How do you compare loans and is the Annual Percentage Rate a good comparison tool? What are your thoughts?

 You’re right in asking how these costs are paid because, obviously, lenders, attorneys, appraisers etc. do not work for free. They must be paid so the answer to your question lies in how the loan is structured. These costs are built into a loan in a number of different ways and there is no clear cut answer as to whether one is better than the other. The right choice will depend upon your circumstances and the mortgage particulars. 

The Annual Percentage Rate was an attempt to make comparisons between different note rates and closing costs easy. Unfortunately, more people are confused by this rate than enlightened because each lender may calculate it slightly differently. The attempt is to factor in closing costs so the resulting rate represents the true, overall costs of the loan. The problem lies in the fact that different lenders have different interpretations of which costs should be included in the calculations. The old saying of garbage in, garbage out makes these rates useless for comparison purposes.&

Since all loans have closing costs, the real question is who pays them and how do they pay them. The easiest and most straightforward way is for the borrower to pay them by rolling them into the loan amount. The payment is only increased slightly and cash is freed up for other purposes. Or a borrower can pay them directly with a check, but this is rarely done as the purpose of a refinance is usually to improve liquidity and cash flow by paying off debt. 

The other option is for the lender to pay the costs and hence the term “no closing cost loans”. If the lender pays these costs, where does the lender get the funds? By increasing the interest rate, there is a premium which can cover a portion or all of the costs. When a lender looks at a rate sheet and prices a loan for you, there is a range of possible rates. At the lower rates you will have to pay the lender for the loan (points, expressed as a % of the loan amount). At the higher rates, the lender will rebate money back, portions of which can be used to pay closing costs. Generally the rule of thumb is that it is better to pay full closing costs if you plan to have the loan for more than three or four years. If you took a no-closing cost loan and had the mortgage for longer, you would pay more in extra payments than the original closing costs. So the rule is to pay full closing costs if you are going to have the loan for a longer period and less if you will have it for a shorter time period. 

But, before you can pick a strategy, you will need to answer how long you anticipate having this loan and what your financial circumstances and goals are for the future. 

Notice that the question is not how long you anticipate being in the house but how long you anticipate having this loan. Often the answer to both of these questions is the same but sometimes they can be different. The nationwide average is less than five years for a mortgage. Future economic conditions today are a real unknown and may dictate how long you will have the loan. Will the high price of oil and the devalued dollar lead to inflation or will the credit crunch lead us into a recession? Or will it be a combination of both, stagflation, as occurred during the 70’s? 

If you think there is a possibility of a recession and lower rates, then you might want to consider paying no costs or reduced costs so you could refinance at a later date if rates dropped again without feeling you had paid closing costs twice. Don’t be hesitant about taking action. I have had some borrowers wait for “the lowest rate” and missed the savings which they could have enjoyed along the way. 

On the other hand, if you feel that inflation or stagflation may rear their ugly heads and you are going to be in the house for at least three to four years, then paying closing costs and getting the lowest rate might be the best ticket. Your monthly savings will be locked in and you will be protected against rising interest rates. 

In addition your personal needs and goals may change. Usually the better strategy is to pull the money out sooner with a larger loan amount rather than later and have the liquidity and flexibility to handle both unexpected expenses or opportunities. Borrowing a larger amount now is cheaper than coming back later with a refinance or an equity line. The only caveat is -Don’t fritter the money away and invest it with a better return than your mortgage costs. 

Finding the best loan program, rate and closing cost structure to meet your needs and financial goals requires many thought provoking questions and analyses. Your mortgage broker, banker or financial advisor are the best sources of information to help solve the question of what is the best strategy to meet your financial objectives. 

The bottom line is looking at the overall cost and return while planning for the future is crucial. Good luck and happy refinancing with these great rates!