THE LENDING GEEK

Telling someone I work using the “no-cost loan” principle usually leads to the feeling of “there’s gotta be a catch.” When you tell someone something that sounds like it’s too good to be true, it usually is. Fortunately for my borrower (but unfortunately for me to have to convince them), it really is just that.

Let me preface this article by noting that this concept can get pretty confusing and technical. I’ll try to explain it as simply as possible, but it can quickly get hairy.

The no-cost loan is not a new concept. It has been around since at least the early ’90s when my brokerage started doing it, but it is not a very widespread concept, especially when dealing with first mortgages. It operates like this: with the money a loan agent makes from doing the loan, he cuts into his commission to pay some or all (ideally) of your loan’s closing costs.

OK, so now it definitely sounds too good to be true.

Why would an agent do a loan where he pays money out of his pocket to help pay for costs you would normally pay at closing? The answer is simple: It’s just good business. Most agents who offer no-cost loans have a steady stream of loyal clients, and while they won’t make as much money per loan as the agents who gouge borrowers, they make it up in quantity and sleep better at night, knowing they’ve done a service for their clients.

To understand it, though, I’ll give you some insight on how a loan agent makes his money: When a borrower comes to an agent, the agent looks over all the applicable financial factors of the borrower to tailor a loan to him. The borrower’s credit report is run, his income documents and bank statements are inspected, and the agent gets a sense for the borrower’s financial make-up. Lenders operate in much the same way when underwriting loans, and also in “pricing” loans.

When a loan agent is browsing lenders to ultimately end up with the lender he chooses, he looks at various “rate sheets” posted each day by the lenders with whom he and his brokerage works. A lender’s rate sheet is divided into different programs (e.g., 30-year Fixed, 15-year Fixed, 5-year Adjustable, etc.) and provides a grid based on each program. A typical program grid might look something like this:

The program is listed at the top (30-year Fixed), and there are two columns: rate and rebate (sometimes there’s a third for length of the “prepayment penalty”, but that’s another topic). The rate column holds the interest rate of the loan while the rebate column has the amount of “points” (the percentage of the loan amount) the lender will pay the loan agent for that particular interest rate. Something to note is that this rebate (sometimes called a “Yield Spread Premium” or YSP by lenders and agents) is not charged to you, the borrower. Rebates are paid directly from the lender to the agent. This is what agents will use to pay for your closing costs: it is literally paid out of the agent’s cut. The only way you “pay” for the rebate the agent gets is by getting a higher interest rate. While that might sound bad and you might think you’d always want a lower interest rate, we’ll see in a minute how that might not always be the case.

It’s probably easiest to look at real-world examples to see the benefit of a no-cost loan with a higher interest rate versus a lower interest rate in which you are responsible to pay for your closing costs. Let’s take a $400,000 loan amount (hey, I’m in California, after all) at 6.500%, 6.750%, and 7.000%. We’ll also assume this is a refinance, and that the closing costs come out to $3,000.

What this table shows is that as the interest rate goes up, the amount of closing costs a loan agent can pay out of his commission also goes up. Now, obviously with a higher interest rate, you’re paying a higher monthly payment. But still considering closing costs of $3,000, let’s look at how much money you’re immediately saving by choosing a 7.000% interest rate over 6.750% and 6.500% interest rates:

Since this is the trickiest but most important part of the philosophy, I’m going to explain it in the most detail. Choosing an interest rate of 7.000% will allow your loan agent to pay all ($3,000) of your closing costs. This is an immediate up-front saving of $3,000 at closing. It will, however, cause your monthly payment to be higher than both the payment at 6.750% and 6.500%, by $66.11 and $132.92, respectively. In both cases, in order to recoup the money you would have paid at closing (if you were to choose either 6.750% or 6.500%), you would have to hold onto the same loan for 23 months ($1,500 paid at closing for an interest rate of 6.750% divided by a monthly savings of $66.11 or $3,000 paid at closing for an interest rate of 6.500% divided by a monthly savings of $132.92).

There are also tax benefits to choosing the higher interest rate. If your combined loans are below a certain limit (depending on your marriage and filing statuses), you are usually able to deduct the full amount of mortgage interest you paid during the year. You should consult a tax preparer before looking into the tax savings, however.

The bottom line is that choosing a higher interest rate and having your loan agent pay your closing costs will save you money up-front, and will continue to save you money if you refinance your loan within about two years. If you would rather hold onto your loan for a longer period of time or just enjoy lower monthly payments, by all means choose the lower interest rate. Be prepared to cut a check at closing in that case, though.

Another very important thing to remember about the no-cost loan is that most loan agents do not offer it, and you should ask about it before entering into a relationship with a brokerage.

I hope I have explained the idea of the no-cost loan well enough. If you have any questions, however, feel free to leave a comment and I’ll do my best to answer your question.

This entry was posted on Sunday, September 3rd, 2006 at 7:00 am and is filed under Education. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.