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No Cost Loan

The "no cost" loan was one of the best lending developments of the 1990s.  This incredible tool saves consumers thousands of dollars while refinancing, and it can be a big plus when purchasing a home, as well.

The "no-cost" loan is arranged with a slightly higher interest rate, usually 1/4 to 3/8%, but there are no closing costs or fees. Since there are no costs to recapture, you can refinance when rates decline and immediately start saving money with no up-front cash investment. For additional information on no cost loan closing costs

Even in a higher rate environment, where refinancing is less popular, the no-cost mortgage may still provide great benefits to individuals purchasing a home. This makes it a great tool on the purchase transaction. 

Most times a comparison is made using the wrong arithmetic. Letís say you have a $200,000 loan. Letís estimate closing costs at $2,300. Your competitor is offering a rate of 7%, zero points with $2,300 in (non-tax deductible) closing costs. You can increase the rebate enough to cover the $2,300 (about 1.125 points) by increasing the rate 3/8%. That means your offered monthly payment is $51 more. Most times borrowers and originators mistakenly divide the $51 monthly savings into the $2,300 cost to come up with a break-even period. According to that math it would be 45 months. But that is inaccurate.

First we need to account for the fact that the money spent has a value. Instead of paying the lender, you should pay yourself first. Do this by understanding that you can apply the $2,300 you were going to throw away on closing costs towards reducing your principal balance. Now the calculation is a $200,000 loan @ 7% = $1,330 per month vs. a $197,700 ($2,300 applied to principal) loan @ 7.375% = $1,365. This narrows the difference to only $35 from $51 per month. Take this one step further in that the $35 difference is tax deductible. Closing costs are not. After the tax deductions are taken into account, the difference is close to $23 per month or a 100-month break-even period.

With the IRS allowing a $500,000 tax-free capital gain on the primary residence of married couples ($250,000 for singles), closing costs are only deductible if the gain on the sale of your home exceeds the tax-free amount. On the other hand, "points" are considered prepaid interest and are deductible in the year they are paid to purchase an owner-occupied home.

Since traditional closing costs are virtually non-deductible and points are deductible, you can use a no-cost loan and buy down the equivalent rate by paying about 1.5 points (1.5 percentage points of the loan amount). In essence, the you trade non-deductible closing costs for tax-deductible points.

The amount of points paid will vary depending on the size of the mortgage and the amount of the closing fees. Letís look at an example:

Imagine you are purchasing a home with a $200,000 mortgage and zero points, and letís say the non-tax-deductible closing costs are in the range of $3,000. This is the equivalent of 1.5 points ($3,000 closing costs/$200,000 mortgage = 1.5% or 1.5 points).

If a you are in the 31-percent federal tax bracket and paid the 1.5 points in lieu of the $3,000 in closing costs, the result would be a cash tax benefit of almost $1,000.

Paying neither points nor closing costs can free up funds to pay down other, higher-rate debts or leave more money available for your down payment. This can also come in handy if you think that the mortgage will be paid off in the next few years via the sale or refinancing of your home.

Avoiding the expense of closing costs in exchange for a higher rate could pay big dividends if you have an opportunity to refinance in the future.

As a Certified Mortgage Planning Specialist, I offer an analysis of your situation today can make suggestions on how small changes in how your consumer and mortgage debt is structured today can have a life changing effect in the years to come.  Read more about this free, no obligation service.

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