To be sure, there is no such thing as a free refinance. When one refinances his or her home, the costs are to be paid by the borrower.
These costs include all the costs that you should expect in a normal mortgage – closing costs that include everything from inspection to legal and banking fees. Refinancing is not cheap, and it is not free.
How No Cost Refinances Work
A no or low cost refinance is a mortgage product in which the costs of a refinance are rolled into a loan. This means that while a no cost refinance does not require any money out of your own pocket, the cost of the refinance is added to the debt, or made up with higher interest rates.
For example, you might pay $2,000 in closing costs on a $100,000 loan to get a 3.5% rate on a 30 year mortgage. However, in a no cost refinance, you might pay $0 out of pocket to get a $102,000 loan at a 3.5% rate on a 30 year mortgage.
Alternatively, you might pay $0 for a $100,000 loan at 4.5% interest.
How can you know which refinance offer is the best offer? How should you compare the difference between lending options to find which one is cheapest over the long haul? It’s actually very simple!
Check the APR!
Banks are required to include all the costs of a refinance in the APR. This means that the Annual Percentage Rate is an interest rate that includes all the costs of a loan. The APR is very different from the APY, which is simply the interest rate that banks charge when they issue a loan.
Therefore, the best deal is always the one with the lowest APR. The best mortgage is not always the mortgage that has the lowest APY. APY is just the interest. APR is the interest plus all fees. Hence, APR compares mortgages on an apples to apples basis. The APY only compares interest rates on an apples to apples basis. If you compare APY to APY, you might just accept a costlier refinance because you do not factor in the costs of closing and other fees into the total cost.
Take a no cost refinance if you can get one, and if it has the lowest APR of all the loan options. In general, no cost refinances have much higher total costs, and it is only the refinances that require out of pocket payments that have the lowest total APR.