The cool thing about doing a home loan refinance is that in most cases it's a really straight forward decision. Either the numbers make sense or they don't. You can't say that about a lot of other financial decisions you make over the course of your life. Have you ever tried to pick out a mutual fund or a stock to invest in? It's not anywhere close to being as straight forward as refinancing.
Most homeowners want to save money in the way of a lower monthly payment or lower interest expense. A home loan refinance is the best way to do this. If you run your numbers and you can save money by refinancing then you should do it.
But to save money, you're going to have to spend some money. The reality with any home loan refinance is that there are costs that have to be paid by someone. When you run the calculations you need to know that there are costs involved otherwise your calculations will be off.
This can be confusing for homeowners because one of the most common refinance options is the "no cost" refinance. But the name "no cost" is a bit misleading.
What is a no closing cost refinance?
First understand that "no cost" actually means "no cost out of pocket."
Refinancing can be somewhat expensive depending on the loan and the interest rate you want to get. A lot of times homeowners don't want to pay the costs associated with refinancing out of pocket. Why drain the bank account when you can do a no closing cost refinance?
The no closing cost refinance is the most popular option for homeowners.
So if it isn't free, how does a no closing cost refinance actually work?
There are a couple of ways to do a no closing cost refinance.
The first and most common is to roll the closing costs into the new home loan. Let's say that you're refinancing a $300,000 loan into a new loan with a lower interest rate. If closing costs are $1,500 you could do a "no cost" refinance and roll the closing costs into the new loan. Now you'll end up with a new loan balance of $301,500. You didn't have to pay anything out of pocket but you are still going to pay the closing costs over the life of the loan.
The second and less common option is to get a "lender credit" that pay for the closing costs in exchange for accepting a higher interest rate. Let's look at the same loan from the example above. You are refinancing a $300,000 loan and you are trying to get a 4.25% interest rate. A lender might tell you that if you accept a 4.75% interest rate they will give you a "lender credit" to cover the closing costs. The reason they are able to offer this is because they make more money off the higher interest rate loan.
But it's not a free lunch! You are paying a higher interest rate over the life of the new loan. With home loans small changes in interest rates equal thousands of dollars. Over the life of a loan it could be tens of thousands. So you have to be careful.
Let's have some fun with math.
Using a simple mortgage calculator at dinkytown.net run the numbers for a $300,000 loan over 30 years with a 4.25% interest rate and look at the "total interest" line item. It should read $231,295.12. Now change the interest rate to 4.75%. Look at what happens. You now end up paying $263,380.12 in interest over the life of a loan. That's a difference of $32,000! You're probably wishing you just went ahead and paid the $1,500 in closing costs yourself!
You can play around with the calculator yourself. I ran the numbers for a 15 year loan as well and the difference in interest was over $14,000 more for the higher interest rate.
Remember that a higher interest rate will lead to a higher monthly mortgage payment.
This just stresses the point that running your numbers is crucial. If you run the numbers and things make sense then you have the green light to move forward with your refinance.
Which no closing cost refinance should you choose?
There really isn't an easy way to tell you what to choose. You have to look at your circumstances and run the numbers for yourself. Check out this post to figure out if you should refinance in the first place and this post on running your refinance numbers.
Remember that the most common option is to choose the "no cost" refinance option and to just roll your closing costs into the loan balance itself. You can keep your lower interest rate and low payment and not have to pay any costs out of pocket.