No Cost Mortgages: Do They Make Sense?
Some people may be aware of the term no cost mortgage, but in truth not many people know what it means and even fewer people understand the benefits and disadvantages of the scheme.
In essence a no cost mortgage is really a refinancing loan that is secured on a property, usually when there is sufficient equity in it. This new loan or 'mortgage' is designed so that borrowers pay no fees upfront to obtain the mortgage.
The catch that comes with a no cost mortgage however is that by not paying any up front fees the mortgage actually carries a higher interest rate, to compensate for this aspect of the loan.
The no cost mortgage is therefore a no up front fees mortgage and not a 'free' mortgage as some people may think; or dream.
Is It Right For You?
Whether or not a no cost mortgage is actually a good or a bad thing is really dependant on the borrower's circumstances and ideas for the loan. In effect the borrower must answer the question "is paying a higher interest rate on my mortgage worth no having to pay any upfront fees?".
With a no cost loan the benefits of paying no upfront fees really only comes if you end up saving money, compared to a traditional mortgage. Normally a no cost mortgage will have an increased interest rate of between 0.25% and 0.6%. If you pay the loan off in a short amount of time then the extra interest that you would pay, when compared with how much you would have paid for a regular mortgage, would be less than the closing (up front) fees and therefore worth taking out a no cost mortgage.
On the other hand, if you end up paying more in extra interest than the values of the upfront fees, then taking out a no cost mortgage will not be the most efficient or cost effective loan in the long run.
The best way to determine whether or not a no-cost mortgage is actually an asset to you or a hindrance would be to calculate the difference in interest and fees. The examples below will help to explain the process in more detail.
Example 1:
If you take out a typical $150,000 mortgage at around 5.5% over 5 years then the amount that you will pay on the mortgage per month would be the following:
Principal & interest = $ 2865.17
+ Homeowners insurance = $ 53.75 (0.43% of price of home / 12 months)
+ Property taxes = $ 150 (1.2% of price of home / 12 months)
= $ 3068.92
With this amount you would pay in total an amount equal to 3068.92*60, which is $184135.2
If you took out a no cost mortgage instead and paid an extra 0.25% in interest you would save the $1725 in upfront fees, however you would end up paying the following
Principal & interest = $ 2882.62
+ Homeowners insurance = $ 53.75 (0.43% of price of home / 12 months)
+ Property taxes = $ 150 (1.2% of price of home / 12 months)
= $ 3086.62
With this amount you would pay in total an amount equal to 3086.62*60, which is $ 185182.2
The difference between the two would be $185182.2 - $184135.2 = $ 1047 This indicates that the amount you will pay in interest over the life of the loan would be less than the up front fees and would be worth it taking out he no cost mortgage.
Example 2:
If you take out a typical $150,000 mortgage at around 5.5% over 30 years then the amount that you will pay on the mortgage per month would be the following:
Principal & interest = $ 851.68
+ Homeowners insurance = $ 53.75 (0.43% of price of home / 360 months)
+ Property taxes = $ 150 (1.2% of price of home / 360 months)
= $ 1055.41
With this amount you would pay in total an amount equal to 1055.41*360, which is $379948
If you took out a no cost mortgage instead and paid an extra 0.25% in interest you would save the $1725 in upfront fees, however you would end up paying the following
Principal & interest = $ 875.35
+ Homeowners insurance = $ 54 (0.43% of price of home / 360 months)
+ Property taxes = $ 150 (1.2% of price of home / 360 months)
= $ 1079.1
With this amount you would pay in total an amount equal to 1079.1*360, which is $388476
The difference between the two would be $379948 - $388476 = $8528. This indicates that the amount you will pay in interest over the life of the loan would be more than 4 times the up front fees and would not be worth it.
However, although taking out such a mortgage would not seem a valid thing to do, it could make sense if you could not afford the up front fess inn the first place. Also if you were to save the upfront fees and invest them you could make more money.
· Example 3.
If you were to invest the $1725 for the same length as the mortgage, in say conservative stocks then the money will generate around 7.5% interest per year. Compounding this interest over the same 30-year period would generate the following amount.
$1725*1.075^30 = $15102.3
This is therefore $6574.3 ($15102.3-$8528) more than what you would be paying in extra interest, and therefore it would be worth taking out the no cost mortgage.
From the calculations above it can be seen that the decision to go ahead with a no cost mortgage can either be advantages or not, depending on the length of the mortgage you are taking out and also your specific circumstances.
