Bad Credit Loans

“No Cost” Mortgage Refinance: Stepping Down the Ladder

[tags]General,,[/tags]

Add to Onlywire

I posted last week that I’m refinancing my mortgage. Now I can add more details. I lowered the interest rate on my 15-year fixed rate mortgage by 0.25% from 5.125% to 4.875% using a “no cost” refi. All closing cost will be covered by the lender. In exchange, my rate is higher than what it could’ve been. If I chose to pay the closing costs, I could’ve got 4.625%.

I’ve done this quite a few times since I bought my house. Every time the interest rate drops, I exercise the built-in put option on the mortgage and do a “no cost” refi. This way I make sure my interest rate is never more than 0.25% higher than the lowest rate. I call this “stepping down the ladder.” The 0.25% number is the typical penalty on my loan amount for doing a “no cost” refi versus paying the closing cost.

I must make it clear that what I did worked for me, in the time period so far. It will not work for everybody. Nor will it work in all rate environment.

With a “no cost” refi, I don’t pay any closing cost at the time of closing. My principal balance doesn’t increase either. After the refi, I pay a lower interest rate than what I had before. I benefit from day one. It removes the biggest uncertainty for any refinancing decision making — “Is it worth the closing cost?” As long as the interest rate is lower, it’s worth it.

“No cost” refi is not really no cost in the strict sense. All parties involved in the refi still get paid. They are paid by the lender via a negative point. Similar to how paying a point buys down the interest rate, a negative point bumps up the rate from what it otherwise would be. For example this time I had a choice between

• pay $3,000 in closing cost and refi to 4.625%; OR
• pay nothing in closing cost and refi to 4.875%

If I choose “no cost” the lender pays the one-time closing cost up front and collects a higher interest over time. If I keep the mortgage past a break-even period, the lender becomes better off. If I don’t keep the mortgage for long, I’m better off. Theoretically if I knew which refi will be my last one and I will keep that loan for a long time, I should choose to pay the closing cost. According to the mortgage refinance calculator 3a by The Mortgage Professor, my break-even period between my two choices this time is 9 years. Because I refinance aggressively and because the rate has been falling, I’ve never held a mortgage for that long. When I refi’d last time, I thought about paying the closing cost because the rate was already low. It only lasted two and half years. I had the same thought this time. In the end I still chose to leave my options open with a “no cost” refi. Let’s see how long this one lasts.

For more info and pros and cons on “no cost” refi, please also read No-Cost Mortgages by The Mortgage Professor (link posted by Taylor Larimore in the Bogleheads forum. Thank you, Taylor.).