Is no-cost refinancing too good to be true?

Posted by  on Mar 10, 2015

Q: I've seen "no-cost refinancing" advertised, and it sounds too good to be true. What does it mean, and what's the catch?

A: The phrase "no-cost refinancing" can be a little deceptive, but that does not necessarily mean it is a bad approach. The key is to understand the actual costs that may be involved.

Normally, there are closing costs and possibly other expenses involved in refinancing. These can be charged up front, but that can be a barrier to homeowners who are refinancing due to difficult financial circumstances. So, a so-called no-cost refinance allows people to refinance without any initial out-of-pocket expense. That might sound good, but it is usually an overstatement to say this form of refinancing has no cost.

Mortgage lenders can make up for not charging any up-front costs by simply charging a higher interest rate over the life of the loan. Given the length of most mortgages and the amount of principal involved, seemingly small differences in mortgage rates can end up amounting to much more than the up-front costs would have been. Another way to avoid those costs is to finance them by folding them into the new loan's principal. This eliminates the up-front cost but will add to the principal and interest you have to pay over the term of the loan.

One way to compare a loan that has up-front costs with one that spreads those costs over the life of the loan is to ask for an Annual Percentage Rate (APR) comparison that includes all up-front costs in the APR calculation. That way, you can see which loan offers the cheapest rate after adjusting for the up-front costs. Even if you ultimately decide to include those costs in the loan principal so as to avoid the initial cost, this methodology will allow you to make something approaching an apples-to-apples comparison. In other words, it will help you see what the "no-cost refinancing" is really costing you.

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