No More No Fee? “Zero-Closing-Cost Mortgages” Face Extinction

A pending change to esoteric mortgage servicing policies puts zero-closing cost mortgages at risk of extinction.

Need a zero-closing-cost mortgage? Get working on it now.

What Is A Zero-Closing-Cost Mortgage?

A zero-closing-cost mortgages is exactly what it sounds like — a mortgage for which the borrower pays no closing costs.

Zero-closing-cost mortgages are used to re-balance your closing costs against your budget and can be applied to purchase and refinance mortgages for all conforming, jumbo, FHA and VA loan types. These include the 30-year fixed, the 15-year fixed, the 5-year ARM and others.

With a zero-closing cost mortgage, you pay literally no closing costs.

Zero-closing-cost mortgages are possible because of mortgage lending’s universal truth — the lower your mortgage rate, the higher your closing costs. It’s a “common wisdom”-type statement you’ve probably read tens of times in your life, but from my experience, the relationship between mortgage rate and closing costs is never really clear to people until they read it backwards.

In reverse, it goes : The higher your closing costs, the lower your mortgage rate.

That clicks with people.

Putting this axiom to life, most people have heard of “discount points”. Discount points are an up-front fee, paid at closing, that get you access to lower mortgage rates than the bank would otherwise offer to you.

Loans with discount points get lower rates so, in other words, you pay additional closing costs in order to get a lower mortgage rate. This is the opposite of how zero-closing-cost mortgages work. With zero-closing-cost mortgages, you pay no closing costs and get a higher rate.

Zero-closing-cost mortgages are like “points-in-reverse”.

When you opt for a zero-closing-cost mortgage, you’re voluntarily accepting a higher interest rate from the bank in exchange for having your closing costs eliminated in full. There are no fees “rolled up” into your mortgage, and no hidden charges or surprises.

Your trade-off for paying no fees is that your higher mortgage rate carries higher mortgage payments each month. The benefit is that you brought nothing to closing and/or kept your loan balance the same.

“My Mortgage Was Sold” Makes A Zero-Closing-Cost Mortgage Possible

When I talk with clients about zero-closing-cost mortgages, it sparks a flurry of great questions, the most common question of which is “How does the bank make money on a zero-cost mortgage?”.

The answer is pretty basic, really — the bank still does gets paid. But, to understand how, we have to spend a quick minute on the “other” side of the mortgage business; the side that deals with monthly payment collection and processing. The part of the business is known as mortgage servicing.

Mortgage servicing makes zero-closing-cost mortgages possible.

With conventional home loans, a mortgage servicer’s primary function is manage the relationship between the homeowner and the agency group backing the mortgage — either Fannie Mae or Freddie Mac. A mortgage servicer’s responsibilities include collecting monthly payments from a borrower and forwarding it to Fannie or Freddie; and, answering inquiries from a borrower about the mortgage.

In exchange, for performing loans, Fannie Mae and Freddie Mac pay mortgage servicers roughly 25 basis points on their portfolios annually, or $250 per $100,000 serviced.

These fees can add up. For example, the largest residential mortgage servicer has over $1.8 trillion in mortgages under management which earns it roughly $4.5 billion in annual servicing fees. These costs are used to hire and retain call staffs and process payments, among other costs. Technology has afforded the servicers the ability to achieve tremendous economies of scale which, in turn, maximizes profits.

In theory, with each new loan serviced, every loan serviced becomes more profitable and this value of “servicing a mortgage” spills over into the mortgage origination side of the business. “Origination” is the process of starting a new loan and the profits that mortgage servicing generates creates huge competition for new loans.

It works like this : Loan servicers contract with lenders to originate loans on their behalf, making commission-type payments called Servicing Release Premiums. A Servicing Release Premium is the premium paid, literally, for releasing loan servicing rights to another entity.

Servicing Release Premiums are based on the long-term value of the loan so, when servicers want to aggressively build their respective portfolios, they offer larger premiums to lender for making originations.

It’s these premiums that offset your closing costs in zero-closing-cost mortgage and it’s part of the reason why your mortgage “gets sold” all the time. It’s not about you, it turns out — it’s about your servicing.

The nation’s largest loan servicers want to manage as many loans as possible to drive down their cost-per-borrower, which increases their overall profits.

That is, until now. Mortgage servicing just became a lot less desirable.

New Lending Rule Kills The “Zero-Cost Mortgage”

In late-September, under the header “Servicing Compensation Initiative pursuant to FHFA Directive”, the Federal Home Finance Agency released a paper called “Alternative Mortgage Servicing Compensation Discussion Paper”.

The FHFA is the regulator for Fannie Mae and Freddie Mac.

In it’s 36-page discussion document, the FHFA outlines new, potential mortgage servicing models for the mortgage industry. It’s Inside Baseball-type stuff that you won’t read in the papers, and probably won’t ever see on television. Heck, most loan officers have failed to read it.

The key points of the document, though, as you’ll want to understand them, are this :

1. The FHFA wants to make sure servicers receive “adequate compensation” for their work
2. The FHFA believes that, under the current servicing model, 25 basis points exceeds its “adequate compensation” target for loan servicers
3. The FHFA proposes a new model in which servicer compensation drops 50% to 12.5 basis points for non-delinquent mortgages

With the proposed changes, mortgage servicers are nervous, and dialing back their aggressiveness. Should loan servicing values drop by half, as the FHFA proposes, the mortgage servicing business is a lot less lucrative, and worthy of examination.

At least one major servicer has left the business altogether, and the others don’t want as many new loans as in the past.

Today’s Servicing Release Premiums reflect this change.

Before the release of the FHFA’s discussion paper, to get a $300,000 zero-closing-cost mortgage in a moderate closing cost state, a borrower could have taken the market’s “base rate” and added 0.250% to it. The extra quarter-percent would have yielded enough Servicing Release Premium to wipe out your closing costs in full.

Today, to get a zero-cost mortgage, take that same base rate and add 0.625%.

Where Fannie And Freddie Go, FHA Follows. Act Now.

In the conforming mortgage market, zero-closing-cost mortgages are now next-to-impossible. Mortgage servicers are wary of over-paying for new loans and, as such, they’ve drastically cut back on Servicing Release Premiums. Before long, everyone — from California to Virginia — will pay discount points for a home loan.

It’s likely that the FHA will be affected, too.

Getting a zero-closing-cost FHA purchase loan or FHA Streamline Refinances will be frighteningly difficult, too. Currently, FHA servicers collect 37.5 basis points for every loan managed annually, or $375 per $100,000 serviced. That’s 50% more than conventional loan servicers earn.

So, even as we see mortgage rates fall over the next few weeks, with “reverse points” shrinking, loan costs will rise. Everything's going to come “with points”.

When loans are less valuable to banks on the “back-end”, they have you pay on the front instead. So, get that rate quote today.