You may have heard of a “no-cost” mortgage refinance. While the advertisements for these products are enticing, they may not be giving you the full story.
The Truth about a No Cost Mortgage Refinance
In reality, there is no such thing as a true “no-cost” mortgage refinance. Any mortgage refinance will have fees for document processing, transactions and taxes, and may also include “points,” which are percentage points collected by the lender to fund the mortgage. Fees and taxes are a part of any mortgage transaction and cannot be avoided.
How, then, do lenders get away with advertising “no-cost” mortgages?
The answer is simple. The “costs” associated with the mortgage are not charged to the client immediately, but are rolled into the principal amount of the loan. This allows the client to refinance with little or no immediate cost, but in the long run may cost more.
In order to understand why no-cost mortgages may actually be more expensive than those which charge fees up front, it is important to understand how a mortgage really works. Most people think of a loan in terms of simple interest, in which a certain amount is charged each month on the principal paid. This is not how a mortgage is repaid, however, and the secret of amortization has allowed lenders to make billions of dollars in the mortgage industry.
Mortgage Amortization and the effect of a No Cost Mortgage Loan
Amortization is the process which accumulates interest on the principal balance each month, beginning with the initial amount of the loan. The secret to amortization is that the interest is charged each month on the principal balance, not in even increments, but in gradually dwindling amounts, spread out over the life of the loan. For example, suppose you borrowed $100 at 10% interest. If you paid the loan at $11.00 per month under a simple interest plan, you would have the loan paid in ten months. However, if the loan was amortized, the first payment might be $9.50 in interest, and only $1.50 in principal. This means that your new principal loan balance the second month is still $98.50, and interest is figured on that amount.
Using this example, it is easy to see how amortization can cause you to pay for years and barely make a dent in your principal. It is in your best interest to have the lowest principal balance at all times—but by rolling in your closing costs, you are actually adding months, and possibly years, to your repayment plan, because very little of that cost will be paid initially, and it will take even longer to get your loan paid off. In the meantime, the lender is making interest money every month on your higher principal balance.
How to accelerate your Mortgage Amortization
There are ways to beat the amortization game. By paying just a bit over your payment each month, and designating that money as “principal curtailment,” you will find that many of your back-end payments will disappear, shortening your loan term. For example, suppose you had a $100,000 mortgage for 30 years at 7% interest. Your payment would be $665.30 per month, principal and interest included, for 30 years. This is actually a total repayment of $239,508! However, by adding an additional $34.70 per month to your payment, making your total payment $700.00 per month, you will actually pay your loan off in 25.5 years, and save a total of $34,595.60 in payments.
It is clear that it is in your best interest to pay more on the front end of your loan, rather than less. Every dollar you keep off your principal results in tremendous savings you to over time. Therefore, before considering a no-cost mortgage, run an amortization schedule and pay with the numbers to see how adding to your payment can reduce your total cost. You can run an amortization schedule here as long as your have loan principal amount, your interest rate, and the number of months you will be paying on your loan. Under the initial information you enter, there is a section to add a particular amount to your one-time payment, or a one-time or yearly amount to principal curtailment.
Why do some people still choose a No Cost Mortgage Refinance?
be No-cost mortgages do have a place. If you are particularly strapped for cash and need a refinance, you can use the benefits of a no-cost plan and later pay more on your mortgage to curtail your principal. However, if you are going to do this, be sure that you borrow only the amount you need, without rolling in a great deal of debt reduction payments as well. If you pay off debt with a refinance without a plan to repay the mortgage quickly, it is easy to find yourself in an even worse financial position when you once again take on credit card or other debts.
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