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In the first part of this two part series, we covered the different types of home loans and the role of a mortgage broker in the “no cost refinance.” Now let’s look at what information we need in order to maximize our savings. As previously discussed, the no cost refinance uses a lender credit to cover the cost to close a refinanced home loan. The lender credit is generated when the mortgage broker sells you a loan at a rate that is higher than the current market rate. This is known as the yield spread premium (YSP). The key to having the YSP work in your favor (cover closing costs) as apposed to lining your mortgage broker’s pocket is being well informed on the market wholesale rate and the YSP compensation.

Unfortunately, there is no clean cut way to decipher these two pieces of information, but there is a way to get a ballpark figure. The best proxy for the wholesale rate is the Fannie Mae Weekly Yield. This rate is published every Monday and corresponds to the yield (return) being offered on their current mortgage backed securities. Since Fannie Mae is a huge agency backed by the “full faith and credit” of the US government, their rates are typically the lowest in the market, so this rate might be slightly lower than what banks are offering your mortgage broker. Once you have a proxy for the wholesale rate, you can determine the yield spread on your loan by taking the rate offered to you and subtracting out the wholesale rate. As an example, let’s say the wholesale rate is 4.5% and my quote comes in at 5.0%, the spread my broker is collecting is 0.5%.

The compensation for this spread is also hard to determine as it tends to fluctuate with changing market conditions, but a good rule of thumb is around 1% of the loan value for every 0.25% above the market rate. Continuing on with our example, let’s say I was getting a loan for $250,000. That would mean the bank issuing the loan would be paying my broker an additional $5,000 (2% of the loan value since my rate was 0.50% above market) for bringing in a loan that was priced better than the market rate. It is this additional compensation that we want to use for closing costs.

The next logical question is, “why would I want to have a higher rate just to avoid closing cost?” This is an excellent question and the answer depends on your time horizon. It’s a bit different for every loan, but typically if you plan on selling your house or refinancing your loan within the next four to fives years, it would behoove you to take on a higher rate and avoid closing costs. After four or five years, the savings from the lower rate covers the closing costs you shelled out, so if you are ready to lock in a loan for the long haul, it may be a better idea to get the lowest rate possible and pay closing costs out of pocket. Without accounting for the time value of money, the basic formula to calculate this tipping point in years would be:

Closing Cost / [(Monthly payment with higher rate - Monthly payment with lower rate) * 12]

After you crunch the numbers, if you decide that the no cost refinance might be the way to go, the next step is to figure out your total closing costs. Closing costs can be broken down into three basic categories — lender fees, third party fees, and prepaid expenses. The first set, lender fees, are determined by the mortgage broker and should be disclosed up front. The second group of fees are charged by all the other “hands in the cookie jar.” These fees can vary from state to state, but most mortgage brokers should be able to estimate a reasonable figure. The last set of expenses includes the ongoing costs of owning a home — insurance and taxes. Since the last group is made up of expenses that a homeowner is already paying and will continue to pay whether they refinance or not, I typically do not roll these into the lender credit. Remember, the more fees you roll into the lender credit, the higher the rate will be to get enough “juice” (or yield spread premium) out of the loan.

Once you determine the dollar amount you need to close (with or without prepaids), you can ask that your mortgage broker quote you a rate with $X of lender credit. Then take your quote and the rule of thumb calculations discussed earlier to see if your broker is getting you a good deal or pulling his best snow job.

Ciao,

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