Upon first glance, one would think that the answer lies in whether you could get a better rate of return on the money that you’d be putting into escrow each month if you kept it and invested it versus the waiver fee.  But there are several factors that come into play when considering which way to go.   For starters, it is convenient for most folks because it is budgeted for and handled by the lender at no extra cost.   This way you’re not hit with a lump sum bill that you hadn’t budgeted for.  If you do have a tight budget or you’re not real disciplined, this is probably the way you should go.

On the flip side, most lenders require three months of reserves to start out an escrow account.  This is a cushion should the taxes or insurance premium go up (as they generally do) the following year.   And if there aren’t enough funds, they hit you up with a shortage which is due either as a lump sum or they will conveniently add it to your monthly payment, which can crimp your budget. 

The biggest problem is that escrow accounts can be difficult for the average person to reconcile, although the lender sends an “Escrow Analysis Statement” at the end of the year.  But too many people rely on the lender to be correct, and millions of dollars go unaccounted for each year by way of escrow accounts.  My advice is to pony up the fee and waive the escrow account.  However, if you’re more comfortable carrying an escrow account, be sure that you can account for every penny flowing in and out of the escrow account.  If you don’t understand the analysis statement, be sure to contact the lender and go over it in detail until you do.

A true no-cost refinance is one in which the lender literally picks up all of the fees, with exception to your escrows (assuming you escrow taxes and insurance) and pro-rated interest.  So you don’t pay any fees; no appraisal, no credit report, no title search, nothing.

So how does the lender do it?  Understanding this requires knowing how lenders are compensated.  Most lenders are compensated by the banks and mortgage companies to whom they sell or broker loans.  Typical compensation for a lender who wants to be competitive is .75 – 1% of the loan amount.  This means that for a $200,000 loan, the lender would be paid $1500 – 2000 for originating the loan.  Each day, lenders receive rate sheets from all of the banks and mortgage companies showing what the compensation is at different rates.  So if at 6% the lender is getting paid 1%, then at 6.125% they would be paid approximately 1.5%, and at 6.25% they would be paid approximately 2%.  As you can see, the higher the rate at which they lock you, the more they are paid.

That is where the no-cost refinance comes in.  Whereas a traditional refinance involves a locked rate based on specific closing costs, the no-cost refinance is at a higher rate with no closing costs.  The lender actually quotes you a higher rate and uses the compensation to pay for the closing costs.  Using the example above, at 6.25% the lender is getting paid $4000 by the bank or mortgage company for originating your loan.  If the total closing costs are only $1600, the lender nets $2400 compensation from your loan, and you paid nothing to do it.  Or did you?

You see, you haven’t yet, but you will.  That’s because when you choose a no-cost refinance option, you’re getting a rate that is .25-.375% higher.  So you’re basically financing the closing costs in the interest rate, something that can add up over time.  Let’s take a look at an example.  The interest on a $200,000 loan at 6% = $1000/month and a $200,000 loan at 6.25% = $1041.67.  So the difference between the traditional refinance and the no-cost refinance is $41.67 higher each month.  That means that if closing costs run $1600, you would start losing on this option after 38 months, which is the break even ($1600/41.67=38.4).

So longer term a no-cost refinance may cost more, but in times where the Fed is cutting rates and they are expected to drop, you may want to choose this option as you can refinance over and over without trying to guess the bottom.

The tightening has been taking place since last year, with the focus being on equity and credit scores, completely ignoring those who may have less than 20% equity or a credit score below 680.  But new guidelines are focusing on who has been responsible enough to keep up with payments, rather than just sticking to a “set” formula.  The focus has been on those who couldn’t keep up, so it’s good to finally see relief for those of us who have making payments on time and doing whatever we have to to keep our heads above water. 

So far, only Fannie Mae has released their new guidelines so your loan must be a Fannie Mae serviced loan (contact your current lender or visit http://www.fanniemae.com/homeaffordable to find out if your loan is a Fannie loan) Some of the most important changes include:

• No PMI required on a refinance if you previously didn’t have PMI.  In other words, if your home’s value has dropped (most likely the case) and you go to refi and you now have less than 20% equity, then you won’t be required to have PMI.
• Ability to refinance a loan with an existing second mortgage where the total LTV (loan to value) is up to 105% of the value.  (Previously this was 95%)
• Relaxed credit score requirements for scores below 680.

As you can see, they are really working hard to help everyone, not just those on the brink of foreclosure.  And I believe many more changes are coming for responsible homeowners, including lower rates.  Stay tuned…