No-cost loans have become a popular alternative for borrowers who are considering refinancing their home loans. With a no-cost loan, there are no out-of-pocket fees or any fees tacked-on to the new loan paid by the borrowers. For example, if a $150,000 home loan is refinanced with a no-cost loan, the new loan balance would still be $150,000. The interest rate on a no-cost loan is usually about a half-percentage point higher than a loan with fees added on.

For example, if a typical loan with fees or “points” added on had a rate of 5-percent, a no-cost loan would have a rate of 5.5 percent. The question is, which type of loan is better: a no-cost loan or a loan with fees? One way to arrive at the decision is to determine the “break-even” point of a no-cost loan compared to a fee-based loan.

Understanding a No-Cost Loan

A no-cost loan isn’t a tricky form of salesmanship or sleight of hand. When a loan broker does a loan for a customer that is higher than the going rate, the broker receives something called a “yield spread premium” commonly referred to as “rebate” from the lender as an incentive for doing the higher rate. Under this arrangement, instead of charging the customer a fee, or adding fees to the new loan, the broker receives his fee from the lender. The borrower doesn’t pay any fees. If the interest rate on the closed loan is .5 percent higher than the normal “par” rate, the broker might receive a rebate of 2 percent of the loan amount from the lender. On a $300,000 loan this amount would be $6,000 (.02 x $300,000.) The broker then pays any fees associated with the loan such as an appraisal, escrow or title fee, out of this rebate and keeps the difference as his profit.

Up front the borrower must choose between a fee-based loan that has a lower interest rate and fees and a no-cost loan that has a higher interest rate, but no fees. This is where the borrower should look at the break-even point, which is the time it will take to “re-coup” the fees that are charged on a fee-based loan versus a no-cost loan.

The Break-Even Point

The comparison between a no-cost loan and fee-based loan might look like this:

1. No-Cost Loan

30-year fixed-rate loan amount: $200,000

Interest Rate 5.5%

Monthly Payment: $1135.58

2. Fee-Based Loan

30-year fixed-rate loan amount: $205,000 (includes $5,000 fees added on)

Interest Rate 5.%

Monthly Payment: $1100.48

Monthly Savings with Fee-Based loan: $35.10 ($1135.58 minus $1100.48)

Since the fee-based loan cost $5,000, the break-even point (with a monthly savings of $29.73)

is 11.83 years.

This is the time it will take to recoup this cost ($5,000 divided by $29.73 equals 142 months, divided by 12 equals

11.83 years.) compared to a no-cost loan.

Considerations Before Selecting the Loan:

• If you’re going to live in the house longer than 11.83 years, you may want the fee-loan.

• If you might move before 11.83 years, you may want the no-cost loan.

• If you think rates will decline in the future, you may want the no-cost loan so you can refinance again

• If you expect rates to rise, you may want to stick with the fee-based loan