Minimizing the upfront costs of a mortgage: What borrowers ought to know

Mortgage borrowers have some control over the amount of cash they must produce at the closing table. Minimizing the amount, however, may or may not be in their long-term interest.

Borrowers can control the amount of cash they are required to produce at closing when they select the combination of interest rate and points from among those offered by their lender. For example, a borrower shopping a $300,000 30-year fixed-rate loan on my site on December 8 was offered the following interest rate/point options: 3.25 percent and $9,298, 3.50 percent and $4,125, 3.75 percent and -$1,160, 4 percent and -$4,875, 4.25 percent and -$8,625, 4.50 percent and -$11,625, 4.75 percent and -$14,625, and 5 percent and -$17,625.

Points are an upfront charge paid to the lender while negative points are rebates credited to the borrower. Rebates can be used only to pay settlement costs.

A major factor is the borrower's expectation regarding how long the mortgage will be in force. Because a rebate mortgage carries a higher interest rate, the cost mounts over time. Borrowers with long time horizons will do better paying points in order to get a lower interest rate, provided they have the needed cash.

Borrowers with relatively short time horizons, say 7 years or less, will save more on upfront costs by taking a rebate than they will lose from the higher interest rate. The two approaches such a borrower can use are to seek either a "no-cost mortgage" or a "no-charge mortgage." The difference is that the latter uses a larger rebate to cover charges that are not covered by the no-cost mortgage.

The term "no-cost" is something of a misnomer. The costs that the borrower does not pay are those that otherwise would be paid to the lender - points and origination fees - plus charges of third parties that benefit the lender, such as lenders' title insurance or appraisal. Borrowers taking no-cost loans do pay per diem interest, tax and insurance escrows, homeowners insurance, owners title insurance if they want it, and transfer taxes if any. A more accurate designation would be a "no lender charges mortgage".

Nonetheless, the no-cost mortgage has the great merit of allowing borrowers to focus their shopping entirely on the interest rate, without fear of fee overcharges. None of the charges that a borrower remains responsible for when taking a no-cost mortgage provide any profit opportunities for the lender. That's why I am a fan of no-cost mortgages, though I would like to see them relabeled as "no lender charge mortgages."

The no-charge mortgage is for borrowers who don't want to make any cash outlays at all at closing. If the rebate is large enough, it will cover all the items enumerated above that are not covered by a no-cost mortgage. The only charge imposed on the borrower that cannot be covered by a lender rebate is the required down payment.

The danger on a no-charge mortgage is not that the rebate won't be large enough but that it will be too large. A rebate in excess of cost is lost - the borrower cannot draw it in cash. Borrowers opting for a rebate need to know the charges that the rebate will cover so that they won't pay for a rebate they can't use.

A borrower can't shop for a no-charge mortgage because there is no way for a lender to know in advance the charges not covered by a no-cost mortgage. The borrower has to select the lender in some other way, and then arrange for a no-charge mortgage.

The easy way to do this is to select the lender recommended by a Realtor or another trustworthy source, apply for the loan, and ask the lender what interest rate you will have to pay to obtain a no-charge deal. That invites the lender to overcharge you, but maybe he won't.

The harder but safer way to do it is to select the lender based on rebate comparisons at an interest rate you specify. Submit an application to the lender you select, then use the GFE you receive to estimate your total charges. With your estimate in hand, inform the lender that you want to lock the price and to forward the complete set of pricing options. From the price sheet, you select the rate/rebate combination that will just cover your charges, erring on the side of insufficient rebate.

Warning: Borrowers taking a no-charge mortgage without a road map that will take them out of their mortgage within 7 years or so will pay a steep price for their shortsightedness.

• Contact Jack Guttentag via his website at mtgprofessor.com.

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