The True Cost of a Free Lunch

The True Cost of a Free Lunch


As a self-described marketing genius, I am blown away by the continued effectiveness of lenders who promote no-cost loans.  In terms of mortgage lending itself, it’s by far the best marketing campaign that has ever been created, (a small notch above stated income transactions for self employed borrowers).  An old saying indicates that “there’s no such thing as a free lunch.” When it comes to rates and fees on a mortgage transaction, that sentence could not be more true.  The recent announcement that Fannie Mae would be hiking up rates again has brought the discussion of how exactly fees are charged back onto the dinner table of the working class.

You may not know this, but chances are you’ve been making your mortgage payment on your current loan to a loan servicer.  Trust me, that’s not a bad thing for your small local lender.  You see, when lenders originate your mortgage loan, they are underwriting it to the guidelines of the program that best fits your needs and goals of the transaction while keeping costs in mind for the perceived riskiness of the borrower.  As a serviced loan, your loan has the best chance for the lowest rate and fee structure available to you.  That being said, whether your lender holds the mortgage note, or is simply a servicer, every loan that is originated generates fees.  I mean every. Single. Loan.  Now I know what you’re thinking: I’ve heard about, and even closed my own loan or loans that have had no fees.  What gives?

Here’s my crash course on mortgage rates and how they are directly related to fees.  Each business day, a lender will post it’s PAR rate (here’s a more detailed explanation of a PAR rate) – the rate at which a full cost loan including loan origination and any pricing adjustments is originated.  There is a trade-off between the PAR interest rate and the fee structure. For every 0.125% that you move up the scale (in .0125% increments) from the par rate, you get a credit back equal to roughly 1% of the loan amount to offset the fees of the transaction. For example, say today you locked in your interest rate 0.250% higher than the posted PAR rate of 5.000%. Your interest rate of 5.250% would have roughly 2% less fees than the same loan at the PAR rate of 5.000% locked on the same day.  The farther you move up the scale from the par rate, the more in credits you’ll receive back at closing to cover costs. Eventually, you will have increased the rate sufficiently to cover all lending costs of the loan in a credit back to you for choosing the higher interest rate above PAR.  This is what the industry calls a no cost loan. Make sense? Here’s an illustration of a new loan amount of $200,000 based on the above explanation of PAR and above PAR rates for the same loan:

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The number that should jump out at you is the interest paid over the life of the loan. Boom. My illustration is driven home about what a no-cost loan isn’t.  As you can see, a no-cost loan simply indicates that you’d rather pay more interest over the life of the loan, rather than pay less fees one time upfront.  It’s not that you’re not getting the loan for free, you’ve just traded paying the fees now, or over the life of the loan.  Now, in some circumstances, having no fees up front can be beneficial, and I promise to explore that at a later date.  But for the most part, free never means free.  Especially in mortgage lending.

One last thing to consider is this. No cost loans aren’t inherently good or bad. it certainly isn’t a scam, and mortgage lenders aren’t trying to pull a fast one on you.  It’s important to remind you that the money is either paid upfront or over time. The associated benefit or cost on each transaction will depend greatly on your unique financial situation with each new transaction.  Make sure you do the math and compare options before signing on the dotted line.  Have your loan officer go through both options for you in detail so you can make the best decision for you, not the bank.  You never know, putting lunch on credit might save you some money.

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