Advice Center

The "No Money Down" and "No-Cost" Options

Nonetheless, a variety of great loan programs today make it possible for aspiring homeowners to purchase a home, even if they don't have much in the way of savings or assets. All they need is stable, reliable income, and a satisfactory credit history.

Programs come with names like AmeriDream, Neighborhood Gold and Nehemiah. All are essentially similar, using a third-party, non-profit corporation to provide a gift of funds to the buyer. The corporation charges a fee to the seller for the service, and uses the fee to fund future grants to other buyers.

These grants can be used for a down payment, for closing costs, or both. Sellers like to participate, especially when the housing market is not brisk, because it broadens the market potential for their homes.  Frequently, sellers will offset the non-profit's fee by negotiating an increased price for their property. Grants are limited to several percentage points of the value of the property purchased.

Not all real estate loan companies participate in these down payment assistance programs, so buyers thinking about using such a program must do a little extra legwork to find the right loan officer and to get the full details about how each program works. Most loan companies that make or broker FHA loans will be familiar with these assistance programs, and each company usually has a specific non-profit that it works with in providing assistance to buyers.

Just as with any other aspect of real estate financing, there are benefits and risks to purchasing with no down payment and no closing costs. Some of the benefits are obvious: (1) easier to purchase; (2) income tax savings from interest deduction on mortgage; (3) creating value from appreciation in housing prices, etc.

The risks are sometimes not as obvious. Making a down payment creates instant equity, a position where the the value of the property exceeds the amount owed on the mortgage. When there is equity, it means that money likely will be available when a house has to be sold unexpectedly. Paying no down payment and no closing costs usually means negotiating a higher price for the property, stretching the market potential of the property to its limit, which could lead to negative equity even in the slightest change in market conditions.

A great way to illustrate this point is with the story of one homeowner. He and his wife purchased a home with a no-money-down VA loan. The market was hot, and he and his young bride planned to start and raise a family in their new home.

In addition to making no down payment, the young couple had the lender roll the VA funding fee into their loan. At the loan's inception, the balance was several thousand dollars higher than the purchase price of the property. But the couple felt secure because the VA issued a Certificate of Reasonable Value estimating the home's worth at more than 5 percent higher than the loan balance.

One day, about a year after purchasing the home, the wife came home to find the entire house in a shambles. A party of burglars had spent less than half an hour in the house, but had managed to ransack and rifle through every corner and crevice. More than ten thousand dollars worth of items were stolen, but sheriff's deputies could find only circumstantial evidence, so the sheriff's office refused to investigate the crime further, despite numerous clues.

The couple got a second dog and installed a burglar alarm, and vowed not to let the mishap break their spirits. The neighborhood seemed like a nice place, with a good school nearby and friendly neighbors.

Then, the young vet and his wife started noticing several gruff-looking, poorly dressed teen-agers hanging around one of the neighbor's houses when they should have been in school.  Occasionally, the teen-agers would be seen walking the neighborhood in packs.

Several weeks after the burglary, the husband arrived home to find his mail rifled and several empty envelopes scattered across the front porch along with the junk mail. He had noticed the teen-agers loitering in his neighbor's yard, and wondered if there might be a connection. How could he ever know?

Later that night, after talking to his wife, he went out to see if the suspected next-door neighbor had yet put out the family trash for the next day's pick-up. The trash cart was sitting in front of the corner of the house, and hadn't yet been wheeled out to the curb.

The husband walked into the neighbor's yard and quietly lifted the lid, truly expecting to find nothing but common household trash. Instead, right in front of his eyes, right on the top of the pile, were an anniversary card and a letter addressed to him and his wife. Furious, he stormed toward the neighbor's front door, but was pulled away by his wife, who called 9-1-1.

Sheriff's deputies responded then, and on another occasion, but took no action either time. No investigation was ever conducted.

After careful consideration, the couple decided they had only two alternatives. The husband could steal into the neighbor's house and shoot the neighbors as they slept. Or, the couple could move. It was a tough decision, but not wanting their visits to be only once a month in a special ward of the state prison, they decided to move.

The husband managed to negotiate a transfer with his company to an office in Oregon. The wife started sending out resumés. 

Realtors® told the couple that the local real estate market was still doing well, so the couple put their home on the market at the appraised price from a year earlier and waited for the offers to stream in. They didn't seek any increase in price from the appraised value because they were serious about selling and wanted the home to move quickly.

About six weeks later they reduced their price by 3.5 percent. After another month or so, they reduced the price another 3.5 percent. The husband's job in Oregon was due to start, but the wife could stay behind and sell the home. She reduced the price another 2 percent. Still, there were no offers after almost six months on the market.

They were trying to sell their home for less than the purchase price, and no one was biting, despite assurances from Realtors® that the market was strong. But, by now, the wife had found work in Oregon too, and she had to leave. She hired a property management company to maintain the home and rent it out.

During the next several years, the couple tried to sell the home two more times as newspapers in the area reported the economy slipping and home prices plummeting. Within four years, home prices in that area of more than 500,000 residents had fallen by more than a third.

The rental market was little better. Though the couple kept the house rented, they were never able to rent it for enough even to cover the interest on the mortgage, let alone the taxes, the insurance and the upkeep required to keep the home in good condition. And, of course, the couple had to pay for housing expenses in their new hometown in Oregon.

The problem was that the couple simply couldn't afford to sell their own home. They owed far more than it was worth, so selling meant that they would have to come up with tens of thousands of dollars from somewhere to pay off their lender and to pay sale costs. They were young, and they just didn't have that kind of money.

They could have stopped making payments and let the bank take back the house, but they were raised to respect their obligations. They also valued their reputation, and they didn't want to ruin their credit rating. Besides, they figured, the numerous credit card offers they received in the mail could work to keep them afloat until they could afford to sell the home.

After 10 years, the couple was bankrupt. They had amassed tens of thousands of dollars in credit-card debt in order to keep up the mortgage and maintenance on their former home, yet the property was still worth far less than they had paid for it. Although husband and wife both worked full-time, they had kept falling farther behind as their credit card bills grew. They had been continually robbing their savings, their retirement and their children's college education to keep up their obligation and their reputation.  And to what end?

Although the housing market in their former home had finally started to recover, prices were still well below their levels at the time the home was purchased. The couple had 2 kids, 2 cars, a dog, a cat and no financial progress, except empty checking and savings accounts and a dozen "maxed out" charge card accounts. Their charge card payments were so high they could only make about three-quarters of the payments in any given month.

Despite all their best efforts, the couple ended up in financial ruin because they didn't have enough equity in that first home when the time came that they needed to sell. Now let's look at what would have happened had they made a down payment when they bought their home.

Although producing a 10-percent down payment on a $250,000 home may not be an easy task for many people, doing so means having to obtain a loan that is substantially lower than the price of the home, only $225,000. This provides equity, or cash value, to the couple on the day they move in. This equity may fluctuate as home prices go up or down, but home prices will have a fair distance to go before the couple's equity reaches a negative amount.

For the couple who bought with no money down, having a 10-percent cash value in their home could have allowed them to reduce their asking price even further. This may well have resulted in a sale, despite the substantial changes that occurred in the market value for homes in their area.

While selling for less than their asking price would have meant a net loss of money in the short term, it would have been much better in the long term. The couple would have had more cash available for current living expenses. They would not have had to take cash advances on their credit cards in order to keep up with their expenses on the extra house. Assuming their employment situations remained relatively stable, they should have had more income for future major expenses, such as raising children and replacing cars as they wore out.

Some people may read this information and say, "That won't happen to me.

"After all," they'll reason, "I plan to live in my house at least a few years, and I know I'll pay down my loan balance with my monthly mortgage payments."

This is exactly how the couple above thought. And while this is the way it works for most people, the reality is that no one knows where he or she will be in two or three years—or even a week, for that matter. New Yorkers on Sept. 10, 2001, never even thought about how their work week would be. It would pass, as usual, as it always had. So much for long-term thinking.

The same was true for millions of Californians in the early 1990s, when real estate markets in cities across the state saw a precipitous drop in values. In as little as a year, home prices plummeted by 30 percent or more in many places. Homeowners who had to move, for whatever their reasons, found themselves losing tremendous amounts of money. And many others, like the couple in the above example, were forced to turn over their deeds to the bank or run themselves into financial ruin.

The fact is, the monthly payments on a 30-year mortgage pay off very little of the balance in the first six to eight years of the loan. In many cases, a strong market and healthy appreciation will make up for the slow rate at which the balance falls in the first few years. But in some cases, they will not. And no one, not even the best real estate broker, the best banker, or the best economist, can predict when a weak market will occur and how long it will last.

When "No Money Down" Can Be The Right Thing

The choice of a zero-down mortgage is good for gamblers. Although few Realtors® or lenders will admit it, there is substantial risk with this type of loan. Even more risky, is the "no-cost, zero-down mortgage," where the loan's closing costs are paid by someone else on the buyer's behalf.

But for those who don't mind taking a chance, these kinds of loans can pay off in a sustained strong real estate market by allowing a home buyer to leverage virtually the entire capital for his home purchase. Using somebody else's money, the buyer reaps the full benefit of the income tax deductions and market appreciation that accrue to the property during the years he owns it.

The primary risk with these loan types is the loss of equity from circumstances such as those described earlier. This loss can be even more pronounced with a no-cost loan. However, if  the buyer is never forced to sell early and in a down market, these loans can provide big pay-offs in the long run.

The Costs of A No-Cost Loan

The term "no-cost" sounds a lot better in advertising than "shifted cost," or "partial cost," so mortgage companies have been glad to embrace it. What the term really means is that the buyer or borrower pays no costs up front.

Every real estate loan involves costs, such as appraisal fees, credit report charges, escrow fees, title insurance fees, document fees, processing fees, flood certification fees, recording fees, notary fees, tax service fees, wire fees, etc., etc. This is true whether the loan is for a purchase or for a refinance. But a no-cost loan program, rather than eliminating costs, shifts the costs onto some other party, such as the seller or a non-profit corporation (though, indirectly, the buyer usually pays through an increased purchase price or increased interest rate).

Even some mortgage companies or loan officers will offer to "pay" a borrower's costs. But how can they do that and still make a profit? To see, let's take a look at how loans are priced and how loan officers earn their income.

Each day, companies with money to loan create rate sheets for the loan officers and mortgage brokers who promote their loans. Interest rates and other costs often vary slightly from day to day. In volatile markets, rates and costs can change several times a day. Each rate sheet will list many different loan programs and the rates and costs that go along with each.

Typically, the information on a rate sheet is listed in tabular form, as in the table below. One column lists a range of interest rates, and a nearby column lists the number of discount points that must be paid for the corresponding interest rate in the same row.

The "Rate" in the first column is the basic, nominal interest rate of the loan (not the same as the annual percentage rate or APR). The "Discount," or "Points," is a stated percentage of the loan amount that must be paid in order to be given the corresponding interest rate. Lenders refer to zero discount points as "par."

In the table above, the interest rate at par (where no points have to be paid) is 6 percent. But a borrower expecting to be in his home for a long time might want to pay a discount, or "buydown," According to the rate sheet, this lender will grant a 5.5-percent interest rate if two points, or 2 percent of the loan amount, is paid up front as a buydown. On a loan of $200,000, two points equals $4,000.

On the other hand, the above rate sheet shows that the lender will pay back two points if a 6.5-percent interest rate is accepted. (The parentheses around the numbers in the lower part of the table indicate negative numbers.) This difference between par and the amount paid by the lender for a higher interest rate is called the "yield spread premium," or "YSP." This amount can be substantial, and it is usually paid directly to the mortgage broker or loan officer who processed the loan.

Why would a borrower pay a higher interest rate if the money paid by the lender just goes into the pocket of the loan officer? The fact is, unless the loan officer is a close friend, most people wouldn't pay a higher rate for this. But most people don't know what the lender's YSP is, and they're not likely to find out.

Just like the owner of your local supermarket doesn't tell each customer what the store pays to manufacturers for each brand of boxed crackers, the owner of your local mortgage company doesn't tell each customer what the company's receipts and disbursements are for each loan. The owner discloses only what up-front fees each borrower has to pay, along with the loan's nominal interest rate and APR.

The rate sheet created by the lender is as secret to the loan officer as are the invoices from Nabisco® to the local grocer. If a loan customer is ever shown a rate sheet, it seldom is the lender's rate sheet, but a rate sheet produced by the loan officer, or his broker or department, that takes into account the costs of the loan officer in doing business, plus a certain amount for profit.

In fact, many wholesale lenders have policies that their rate sheets are not to be reviewed by borrowers or the public. They are for the benefit of the employees or brokers who process their loans.

This brings us back to how a loan officer can afford to pay loan costs for a borrower. Loan officers who offer to pay closing costs do so by adding a sufficient amount to their own rate sheets to make up the costs they will have to pay. This means a higher interest rate to the borrower, but a lower up-front cost. Loan officers, after all, are in business to earn a living, and no one can earn a living by giving things away.

How this works can be illustrated with the following example. Lender Acme Inc. faxes the above rate sheet to mortgage broker John Smith. As soon as he receives it, John Smith figures in all of his current costs and creates a new rate sheet, which he distributes to all the loan officers in his company, River City Brokerage.

A comparison of the two rate sheets above shows that the rates and points are not the same in both. After looking at Acme's rate sheet, John figured he needed to add in extra to cover his cost for building expense, utilities, employed staff, commissioned staff and profit. He also allows his loan officers to offer a no-cost loan program with the borrower's closing costs being paid out of the difference between the points shown on the lender's rate sheet and the points shown on the no-cost rate sheet shown below.

Notice that the spreads between the interest rate and points quotes increase even further in the "no-cost" rate sheet, and the APR, or annual percentage rate estimates rise also. Basically, this is because River City Brokerage rolls its additional costs for the no-cost program into the interest rates that the borrowers must pay.

As for the commission the loan officer receives, that depends on the contract between the loan officer and his employer (the brokerage, bank or credit union where he works). Fee splits between a loan officer and his employer vary by company, but most contracts include an arrangement for the loan officer to receive at least a portion of any YSP retained by the mortgage company, with the balance going to the company itself.

Considering all of this, it is natural, and usually correct, to assume that companies that charge higher fees often have slightly lower interest rates while companies that charge lower fees often have slightly higher interest rates. Hence, shopping for a loan based only on fees can mean a higher cost in the long run because of a higher interest rate.

In our example above, the borrower actually would have to pay an interest rate of 6.25 percent to get a loan without any points, not the 6 percent quoted on the rate sheet of the company actually loaning the money. To have his costs paid by the mortgage company and also not pay any points, the borrower would have to pay an interest rate of 6.5 percent.

Well, then, why wouldn't a borrower just go directly to the lender or bank to get the loan and bypass the broker or other mortgage company acting as the "middleman"? The fact is, the total cost of borrowing is often about the same either way, and many of the largest wholesale lenders do not make loans directly to consumers. The lenders who do make loans directly to consumers may charge a lower interest rate, but often charge higher fees to make up for the processing they must do when there is no middleman involved in making the loan.

Another way that some loan costs can be covered without the borrower having to pay them up front is to simply add them on as part of the amount being financed. Some lenders will allow this, while others will not.

Whichever method is used, the risks are real and high. Rolling costs into the loan amount reduces the owners equity in his property immediately. Paying a higher interest rate ensures that the loan payments will more gradually decrease the loan's balance, especially in the early years.

Whether it makes sense to take out a no- or low-cost loan is a decision that only a fully informed borrower can make. Mortgage companies offer these loans for a reason. Essentially, the mortgage company involved agrees to forgive some compensation today (fees) because of the promise of greater compensation tomorrow (a higher interest rate).

Borrowers need to be aware that the mortgage company's future compensation usually far outstrips the amount that would have been paid in fees at the time the loan was obtained. Thus, when buying property, it may be better to negotiate with the seller to get him or her to pay buyer closing costs rather than to obtain a no-cost loan.