The Mortgage Professor

The Cost of 'No-Cost Mortgages'

By Jack Guttentag
Saturday, September 22, 2007

In a recent column, I discussed Bank of America's new no-fee loan program for home buyers, under which lender and third-party fees are absorbed by the bank. On a fixed-rate mortgage, the borrower would pay the interest rate and points, and that's it. Price shopping would be so much easier, I mused, if all lenders did the same.

A spokesman for another large lender responded to that column by claiming that other lenders do offer the same product, but they give it a different name. They call it a "no-cost mortgage."

I will explain what he means with an oversimplified example. A lender who absorbs all costs in its rate and points must mark up the price accordingly. For example, if Bank of America is prepared to absorb $3,000 of costs including third-party charges to acquire a $300,000 loan at 6 percent, it will price a no-fee loan at 6 percent and zero points.

Now consider Lender X offering the same loan and facing the same $3,000 in costs, except that the costs are billed to the borrower. This lender offers 6 percent at minus-1 point, which is a rebate to the borrower. (A point is an amount equivalent to 1 percent of the loan value.) The borrower selecting the 6 percent mortgage on which the rebate just covers the $3,000 has a no-cost mortgage from X that appears identical to that of Bank of America.

In other words, the borrower from Bank of America pays 6 percent and nothing else. The borrower from X pays 6 percent plus $3,000 in fees but receives a $3,000 rebate from X.

But there is a critical difference. Lender X probably does not guarantee upfront that the charge to the borrower will be $3,000. A few lenders guarantee their fees; even fewer guarantee third-party fees. All the rest provide estimates, which sometimes have a funny way of escalating as loans move toward closing. So the borrower dealing with X might end up with a rebate worth $3,000 and be billed for $4,000 in costs.

Most borrowers are not aware of the no-cost option from lenders. The loan officers and mortgage brokers with whom they deal are unlikely to volunteer the information because no-cost loans are easier to comparison shop. If the borrower requests a no-cost quote, they will comply, but the quote is based on cost estimates that can be far off the mark.

Borrowers can roll together their own no-cost mortgage online. They do this by selecting an interest rate that carries a rebate large enough to cover the settlement costs. This requires that they have access to the complete range of rate/point combinations offered by the lender, as well as the settlement costs. Unfortunately, few lenders provide this information on their Web sites.

If you expect to have the loan five years or longer, you don't want a no-cost mortgage unless you are desperately short of cash. If you have the cash, it pays to buy down the interest rate by paying points rather than the reverse. This calls for a revision of your shopping strategy, from finding the lowest no-cost rate to finding the lowest cost at a specified rate below the no-cost rate.

For example, if a 30-year, fixed-rate mortgage with no closing costs is available at 6 percent, set 5.5 percent as your shopping rate and find the lowest costs at that rate. With Bank of America's program, it will be the points charged on the 5.5 percent loan. With other loans, it will be the sum of lender and third-party charges at 5.5 percent. Again, it may not be easy to find this information online.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site,

Copyright 2007, Jack Guttentag

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