With interest rates so low, and going lower by the day, many people are thinking about refinancing their homes. One ploy that mortgage companies use to incentivize refinancing is the “No Cost” Refinance. Most people know that getting a mortgage involves costs: fees, escrow, appraisal, etc. When calculating your return on refinancing, most people look at the savings realized versus these costs. However, now there are companies that are waiving these fees – for a price.
The Old School Refi Math
When you refinance, you have to pay all sorts of fees. Here is a breakdown of some common fees and their amounts for a $400,000 loan.
- Origination Fee: $1,190
- Prepaid Interest: $384
- Flood Insurance: $19
- Tax Fee: $65
- Escrow: $450
- Recording: $25
- Doc Fee: $20
Grand total: $2,153
That is a lot of fees. So, if you were going to get this loan refinanced, it would cost you $2,153.
Let's say your current rate was 5% for a 30 year fixed, and you were going to lower it to 4% for a 30 year fixed.
You current monthly payments would be $2,147. If you refinanced to 4%, you new monthly payment would be $1,910 – a savings of $237 per month. So, you would get your money back on the cost of the refinance in about 9 months.
It is important to remember that you could be adding to the term of your loan – if you were two years in, you are now back to a 30 year loan – so this plays a part in the reduced rate. As such, you do pay interest on the longer term, but since it is at a lower rate, you usually save here.
No Cost Refi Math
Let's assume the same loan structure as above, with the same fees. With a no-cost refinance, you never get the best rate, you pay a higher rate. Essentially, your fees are being rolled into the interest rate, and the company will get paid back through the higher interest payments.
So, if you wanted a no-cost refinance, you would most likely only be able to get a rate at 4.5%. It would lower your monthly payment to $2,027, which is still a savings of $120 per month. However, here is where it is important that you look at the total interest paid and see the deal you are really getting.
Total Interest Paid at 4%: $287,478
Total Interest Paid at 4.5%: $329,626
It is important to understand that this is over 30 years, and most companies will sell your loan within 1 year, so they will not fully realize that difference. As such, they will calculate the net present value of your payments to get a more realistic current figure.
NPV at 4%: $10,811
NPV at 4.5%: $11,869
Which is Cheaper Up Front?
Now that you see the math, which is cheaper up front? Well, the better deal up front is actually the no-cost refinance, because the NPV is $11,869, but that money is used towards your fees, so the bank only sees $9,716 ($11,869 – $2,153).
You have to remember that the broker will get their commission, and the bank will realized their current profit based on this number. So, by you making them pay your fees, you make out better than the bank.
However, over the life of the loan, you lose, because you pay $42,148 more in interest. And, if you calculate the NPV of $42,148 over 30 years, with a discount of 0.5% (the difference between the two), the value if negative, which means that you will not receive the return on the money to make up for it, and that it is not the optimal decision.
The bottom line is that you should usually pay your own costs to get the lowest rate. However, you should ask yourself these questions:
- If it is free, and it is lower than what you are paying now, why not?
- If it is free, and rates go down even more, could you do a no-cost refinance again and save even more?
- If it is an investment and your tenants are paying your interest, should you even care that much, especially if it is no-cost?