Zero Cost Real Estate Loans

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Got a question asking if zero cost loans really exist. They do. I've done several dozen myself, for clients who listened to me about the nature of the loan market.

Let me define what a zero cost loan is. It is a loan with a higher rate deliberately chosen so as to get a high enough rebate, or Yield Spread, to cover not only the loan provider's margin, but all closing costs you would normally have had to pay as well. So that except for any cash you get, your loan balance should not increase by a single penny.

Even on a zero cost loan, you're likely going to write a check or even more than one, but they are for things like Prepaid interest. Prepaid interest is not a cost; it's paying money that you would have owed anyway in a slightly different manner, a little sooner than you otherwise would have, and you will get it back by not having a payment the next first of the month. Matter of fact, prepaid interest is the reason there is no payment due on the first of the next month. You're not skipping a payment. You never skip a payment, and any contention to the contrary is reason enough not to do business with that particular loan provider. You generally have the option of rolling prepaid interest (along with other prepaids) into your mortgage, but then you're paying interest on it and it's stuck in your balance forever. Ditto an impound account. That is your money, not a cost of the loan. We are talking zero cost here, which is an entirely different thing from the lender absorbing money that you would have had to pay anyway. But in a true zero cost refinance, no money gets added to your loan balance. $X before the refinance, and $X after, not $X+6000. You will likely need to pay for the appraisal (if required) out of pocket when the appraiser comes out, but you get that cost refunded upon funding for a net zero out of pocket. True zero cost. This does entail accepting a higher rate, and therefore higher payments than you might otherwise have gotten, but if you only intend to keep the loan a relatively short period of time, you start ahead by doing this and there is not enough time for the lower payments to break even. For instance, a while back I had a par rate of 6.25% on a thirty year fixed loan, but providing your balance was at least a couple hundred thousand, I could do 6.625% for literally zero cost. If you were planning to sell in two years but your current rate was eight percent, as many people have nowadays, but their credit has improved now to where they qualify A paper, this saves them a lot of money for literally zero cost, so there are no "sunk costs" to recover; it's pure profit from day one. I happen to think that with rates as volatile as they have been the last few years, it makes a lot of sense to choose a zero cost loan. If rates go down half a percent six months or a year from now, you can go get a rate that much lower for zero cost when they do. If you paid two points to get the rate, it's going to cost you the same two points again to benefit by as much.

Now this is not to say that you shouldn't be on your guard when someone talks about a zero cost refinance. What most lenders mean when they say "zero cost" is "No money out of your pocket" while rolling thousands of dollars (including multiple points) into your loan balance, where you not only pay them, you pay interest on them. Many lenders will talk about putting money in your pocket, when what they are doing is adding not only that money but all the costs and all the points to your loan balance, and people who have been doing this every two years wonder why their loan balance is ten times their original purchase price. I call these Stealth Cash Out Loans. There is no such thing as a free lunch. You paid for the cash out; you're going to be paying for the cash out for many years, just the same as you paid for your closing costs in the previous paragraph with a higher rate than you would otherwise have gotten. The difference is that money added to your balance tends to stick around for as long as you own property, whereas a higher rate is over as soon as you sell or refinance that particular property. If you choose a zero cost loan, your balance should transfer straight across; you are continuing to pay it down as soon as you write the first check on the new loan. Whereas if you chose a loan that adds thousands of dollars in closing costs etcetera to your balance, it's going to be years of payments before you're back where you started. Here is a list of Questions to Ask Prospective Loan Providers in order to pin down what they are really offering.

There are two reasons not to consider zero cost loans: First, if you have a history of keeping loans a long time between selling or refinancing, you will usually more than get your money back within some number of years. Second, if the tradeoffs between rate and cost are shallow enough so that you are likely to get any money you actually spend back fairly quickly. At this update, the slope of the tradeoff curve is so shallow that you're likely to get the money for closing costs back within six to eight months. But that's an individual computation at the time you start your refinance. The higher rate for lower cost is often better for your pocketbook.

A true zero cost loan not only has no net "out of pocket" expenses, it has literally zero added to your mortgage balance. They do exist, mostly for well-qualified A paper borrowers, despite what certain skeptics might say, and for most people who qualify for them, they are something you should strongly consider in most markets, whether you're planning a purchase or a refinance.

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This page contains a single entry by Dan Melson published on March 7, 2009 8:00 AM.

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