If you have financed more than one mortgage in your lifetime you are likely aware that one of the marketing “tools” that those of us who sell mortgages have had is the no closing cost refinance. It has been a tried and true method of managing your mortgage if you are a consumer and managing your database of closed clients if you sell mortgages.
If you are not familiar with the no-cost refi, or need a refresher, let me explain it briefly.
Your mortgage is a liability to you but is an asset to the bank or broker that is creating it. The asset is the right to collect your payments, which is sold at the closing. If on any given day, a mortgage rate is 5.5% with zero points and $2000 in closing costs, there used to be a rate of 5.75% or 5.875% available with no closing costs as illustrated in the chart below.
So what happens to the costs in a “no cost” loan? The short answer is nothing. The costs remain but the broker pays them. The title company, appraiser and other third parties do not waive their fees. The bank also collects an underwriting or funding fee on every loan. None of the service providers waive their fees for the consumer.
The way that the broker pays the costs is to increase in the fee paid to the broker for the right to collect the payment called the Yield Spread Premium (YSP). Simply put, using the sample we gave before, the broker sells the loan at the higher rate to the bank. The bank pays roughly $2000 more for the loan at the higher rate. The broker uses the $2000 to pay everyone the closing costs and the mortgage now is “no cost” to the consumer. The broker nets the same amount for their work in securing the mortgage so they are happy to make this deal.
The choice for you as the consumer was do I take the lower rate and pay the fees or do I take the higher rate and payment but pay nothing up front. In the example above, do you take the $40 per month higher payment and save $200 in cash, which would take 50 months or over four years to break even? Usually it made sense for most folks to take the no cost option as rates were falling and the option of refinancing multiple times over the course of a year or so was made prohibitively expensive because the closing costs had to be paid in cash each time. This is also known as financing the costs into the rate.
This brings us to the death of this loan and the trouble it is causing in todays’ busy mortgage market. Banks have stopped paying any significant amount of YSP to the broker for the right to collect the payments. Here is a sample comparing a rate sheet from last spring when we had a very brief drop in rates to one since from last week with similar rates using the same $250,000 loan example.
This drop in what banks are paying for mortgages can be attributed to several factors.
First is that more loans than expected are going to foreclosure. With the uncertainty in today’s economy, you may feel comfortable about your income prospects but lenders don’t. It’s not personal; they feel that way about everyone. Second, if rates drop more later, (a big “if” that I address here) banks will get crushed because all of the loans that they are spending money to purchase today will pay off long before the collect many payments. Third is that after two years of falling profits and rising losses on mortgage portfolios banks are overwhelmed by refinance demand. Just like any business, if you can sell all you have at today’s prices, why would you cut your prices (or pay more for them).
As you can see by the chart, it is now difficult if not impossible for brokers to do what they did before: pay the closing costs from the extra YSP if you wanted a 5.75% rate instead of 5.5%, the YSP would only provide an additional $250 toward your closing costs. To get anywhere close to the YSP needed to pay all the closing costs on a loan, the rate needs to rise to 6.375% where it would not likely make sense to refinance.
In today’s market, the reality is that the best deal is likely to include the customer paying their closing costs. It is a shift in mentality but one that each consumer must understand is critical to getting the best deal to secure their financial future.
