Take a no-cost refinance when you expect to be in the house for a long time.

There are no-cost loans out there but you will pay a significantly higher rate than if you pay the costs yourself. If your existing mortgage rate is higher than the current rate on a no-cost mortgage, then "yes", you can reduce your rate without it costing you anything. But that doesn't mean you should.

It all depends on your time horizon. If you expect to be out of your house within 2 or 3 years, or you are not sure and want to hedge, the no-cost loan can be a good deal. If your time horizon is longer, the no-cost loan should be avoided. There is no reason to choose a no-cost loan because you are strapped for cash, since it is usually possible to include the costs of refinancing in the new loan.

If you shop for a no-cost loan, make sure that you and the lender agree on exactly what it means. It is not "zero points" which leaves you responsible for other types of lender fees as well as other payments to third parties. It is not "zero fees" which still leaves you responsible for payments to third parties. And it is not "no cash" because that could mean that you are paying the costs but the lender is increasing the loan by enough to cover them. On a true "no-cost" loan, the lender collects no fees and pays all other settlement costs on your behalf without increasing the loan amount.

There are only two kinds of payments borrowers should expect to make on a true no-cost loan. One is per diem interest, which is interest from the day of closing to the first day of the following month. On a refinance, you will also pay interest from the first of the month to the closing day. The other outlay you should expect to pay is escrows, though on a refinance you will get credit for escrows held by the old lender.

I am frequently asked whether you can tell if you have a no-cost loan from the APR? The answer is, "yes and no". If the APR is greater than the interest rate it means that you are paying some lender fees and don't have a no-cost loan. However, the fact that the APR equals the interest rate doesn't necessarily mean that you have a no-cost loan because not all settlement costs are included in the APR. You are not paying any of the fees that are included in the APR, but you might still be paying some other settlement costs.

On February 2, 1998 I shopped for a no-cost 30-year fixed rate loan in an area where settlement costs (other than fees to lenders) were 2.75% of the loan amount. The best rate I could find was 8.625%. This means that a no-cost loan would make no sense for me unless my old loan had a rate above 8.625%. On the same day I could have had the same loan at a rate of 7.125% and zero points, where I would be responsible for the settlement costs. Which is the better choice?

My way of answering the question is to view the costs that I must pay on the 7.125% loan as an investment, with the return consisting of the saving in the monthly mortgage payment plus the faster repayment of the loan balance. I calculated that if the loan remains in force for only 12 months, my return would be n egative and the no-cost loan would be the best choice. If the loan runs for 24 months the return on my investment would be 7.7%, which is a so-so return that would leave me on the cusp. If the loan runs for 36 months, however, the return would be 31%, which is a clear winner. These numbers should be typical of those you would find if you shopped the market yourself.

The upshot is that no-cost loans are a good option if you expect to move within 2 years, and a poor option if you expect to remain for 3 years or more. The longer you expect to be in the house, the more attractive it becomes to get the lower interest rate by paying the settlement costs.

A no-cost loan might also be a useful stopgap in situations where you think you might move shortly but aren’t sure. You can save some money while waiting for the situation to clarify, and if it turns out that you are going to stay put after all, you can refinance again later.

Updated November 1, 2002