If interest rates are low, how can banks make money when they refinance a mortgage? After all, if inflation goes up in the future, the bank will actually end up losing money. As a solution to this query, many lenders started to charge fees to make and process loans. That makes it confusing to connect the dots when some lenders advertise zero cost refinance programs. Does that truly mean a free refinance? Can you refinance with no closing costs?
Many refinance products can be structured where the borrower does not pay the fees out of pocket, rather the costs can be absorbed over the life of a loan. This is known as a no costs refinance. Let’s explore when it makes sense to use a no cost refinance, and how they work.
Average cost of refinancing
Refinancing is not a cheap ordeal. For a typical mortgage refinance a borrower will usually pay between two and three percent of the total loan cost in fees – a sizeable amount of money. For a loan of $500,000, the total cost of a refinance could cost around $15,000.
These closing costs are spread out between lenders, originators and third-party vendors who all charge a vast range of fees to place a new loan. These fees include (but are not limited to):
- Loan origination fee
Most of the cost involved in a refinance comes from originating the new loan. This fee is usually 1 percent of your total loan value. So, if you are originating a loan for $500,000, your origination fee would be around $5,000.
- Lender fees
The exact refinance cost that lenders charge varies depending on the lender and the type of loan. They generally levy small charges for such things as accepting an application, issuing a credit check and generating the loan paperwork. A typical application fee could cost anywhere from $200-500 depending on your lender.
Many homeowners will also need to get an appraisal to show their lender a loan-to-value ratio before being approved for financing. Appraisals can cost around $600. If you refinance through a streamline program, you may be able to forgo the appraisal.
- Title and closing fees
In most states, a title company or a title company and attorney handle the process of actually getting the loan closed. They coordinate getting the paperwork together, getting signatures, and sending the money to the right place. A title company also ensures that there is no one else that might be able to lay claim to the property and harm the owner’s or lender’s right to it. They charge for all of these services and the fees vary greatly.
- Private mortgage insurance
If you don’t have at least 20 percent equity in your home, you may be on the hook to pay private mortgage insurance. Private mortgage insurance typically costs between .5-1 percent of your entire loan amount, annually. So, for a loan that is $200,000 you would pay $2,000 each year on PMI.
If you currently pay private mortgage insurance, but an appraisal shows your home value has increased enough, you won’t be required to pay PMI any longer.
- Prepaid expenses
Finally, some loans will require that some expenses be prepaid. These items may be listed as “Items Required by Lender to be Paid in Advance” and “Reserves Deposited with Lender” on a settlement statement.
The most common prepaid expenses are:
- Mortgage interest that will accrue between the closing date and month-end
- Real estate taxes paid into an escrow account
- Homeowners’ insurance paid into an escrow account
Note that homeowners insurance is different than private mortgage insurance. Private mortgage insurance protects a lender against loan default whereas homeowner’s insurance protects homeowner and lender against property loss and liability issues
You can request a good faith estimate from your lender to see roughly how much you would need to pay for all closing costs. A good faith estimate should break down, in detail, what fees you’ll be charged and how much each fee will cost. You can compare good faith estimates between different lenders to see who can give you the best deal.
Average cost pay off an old mortgage
Additional to closing costs, there are fees associated with paying off an old debt that you may not think about. Take these two common refinancing fees:
- Reconveyance fee
A reconveyance fee is charged by lenders who formally give up their right to your property so that your next lender can take it as collateral. This fee is typically in the neighborhood of $100.
- Prepayment penalty
While most traditional fixed-rate mortgages do not carry prepayment penalties, some jumbo and subprime loans do. These penalties vary wildly depending on the actual rate and terms of the loan getting prepaid but some can cost around 80 percent of six months interest.
For instance, if a borrower has a mortgage rate of 6.5 percent on a $500,000 loan amount, that borrower is paying close to $2708.33 per month in interest. 80 percent of monthly interest for six months comes out to about $13,000.
Considering a zero cost refinance
Seeing all of these expenses broken down can be intimidating. If you fear you won’t have enough cash on hand to cover the costs of a refinance, you might consider a zero cost refinance.
What is a no closing cost refinance?
Is it actually free? This is the catch, not really. If your lender can’t earn money on low loan interest rates, they will surely need to collect on the one-time charges to originate your loan, at some point.
There are typically three ways to pay refinance fees:
- In cash at closing
- Adding them to the loan balance
- Or by having the lender pay them in exchange for charging a slightly higher interest rate.
When you use a no closing cost loan, you still pay the fees. No cost refinance options tend to have higher interest rates – a way for the lender to recoup some fees. So, instead of a borrower paying closing costs up front in a lump sum, you pay a little bit extra over time.
The cost gets added – in tiny chunks – to each monthly payment you make.
Are no closing cost refinances a smart decision? It depends on your personal financial situation. (Photo/Wikimedia Commons)
When does a no closing cost refinance make sense?
No closing cost mortgages are perfect to borrowers who:
- Don’t have the money to pay closing costs upfront.
- Borrowers who don’t plan to stay in their home long enough to break even.
- If the current mortgage rates are high, and you expect them to drop soon.
When doesn’t a no cost closing refinance make sense?
- How much higher will your interest rate be with a no cost closing? How much more will you pay over the life of the loan? Use a mortgage calculator to determine if the upfront cost is actually a less expensive solution.
- Interest rates are low, and you expect them to rise.
- If you have the cash to purchase a short-term loan, like a 15-year fixed rate, you will save more money by using this strategy.
Other considerations for closing costs
Some loans allow the borrower to “buy the rate down” by paying discount points. For example, if a borrower pays one percent of the loan as an upfront fee, the lender would reduce the rate by 0.25 percent. After approximately four years, the borrower would have gotten their money back and would have 26 additional years of payments at the lower rate. Discount points can be a good investment for borrowers who know that they will be holding on to the property and its mortgage for a long time. These costs are not usually included in the average refinance fees for a new mortgage.
Using a mortgage calculator to assess the fees
You’ll be glad to know that even after all of the fees, refinancing usually nets significant savings. As long as a borrower can reduce their interest rate by at least 100 basis points, or one percent, they will almost always come out ahead doing a refi. Some borrowers who refinance away from high-rate subprime loans can come out ahead in less than one year.
Use a mortgage calculator to compare your current loan terms against refinancing options. You can also determine your breakeven point, which is when you’ve covered the cost of your refinance and are reaping the rewards of lowered monthly payments.
Most lenders offer a no closing cost loan. Shop around and compare your products.
Ultimately, most borrowers need help in choosing the right type of refinance mortgage and the right way to structure it. A qualified mortgage broker can do this for borrowers. They also help to streamline the paperwork and get the loan closed more quickly. With their help and today’s attractive low rates, just about anyone can save a great deal of money on their mortgage.