I am first time home buyer and purchased my home last year. I got 100% financing for my home loan which was structured as 75-15 by the lender. Just recently I spoke to my lender regarding REFI and after reviewing they suggested a 100% FHA loan. In addition it was a 0 closing cost REFI and all I had to pay was $350 for the appraisal fee. I got the paper work from them with all kind of information and figure. It sounds too good to be true because one thing I have learned, there is no such thing as free lunch. So my question to them was how they are doing a $0 closing cost. According to the lender the only reason they are willing to extend this offer is because of my second loan is also with them. Therefore they are willing to cut the second loan amount enough to cover the closing cost. My next question was, could I receive like a 1099 (income/credit) from Uncle Sam down the road for the closing cost? Because the HUD estimate shows an amount of $6000 for the "Cost to/from borrower." According to the lender, I should check my accountant regarding this but based on what he heard from other customers who have gone with the offer, it wasn't the case.

I did my research on Google regarding such loans and it sound like the lender is trying to get rid of second loan just because they are not secured. With the rate of defaulters increasing they are trying liquidate them and convert it to 100% fha loan.
With the grace of god I have been current on my mortgage payment and I am not in any foreclosure type situation, but I also inquired with my lender if I am being considered as a potential defaulter because I don't want to have any problem down the road when I get ready to sell my house. And he said that wasn't the case.
I have given them the benefit of my doubt but I still wanted to share this with others to get their opinions.

There are three issues here:
1) UNDER LAW, they have to send the IRS a 1099 form and this income becomes taxable... (ask your accountant!)... furthermore, you may have to pay estimated taxes on the first day of the next quarter after the event or possibly incur interest and penalties at tax time.

2) No matter how they structure this, they will have to reduce the principal amount of the loan to do this in order to cover the closing costs and PMI (see below). NOW... if they do this, they can legally report to the credit agencies that this loan was "Legally paid in full for less than the total amount"... this is NOT a good thing to have on your credit report.

3) FHA loans have PMI... 1.5% initially (typically financed and added to the loan amount) and a monthly amount based on your credit score... The question for you... will the resultant monthly payment be lower considering the PMI??

#2 may be negotiable with them, issue #1 isn't.

It's NOT a zero closing cost loan... you are borrowing the closing costs.

***The above is not legal or financial advice but rather based on my experience as a loan officer***

Sandkicker thanks for your response.
I had given up checking this thread since no was answering my question and it wasn't till today that I found it was answered. Thanks and your info was really helpful.
Few additional questions
1) How is this not a no closing cost loan? How am I borrowing money? I don't seem to understand. Are you saying this because I will be receiving a 1099? When I looked at the HUD estimate I don't have to bring forward any money towards closing. So to me it seems pretty clear that it's a no closing cost. Am I missing something here? I did ask them about principal reduction and credit agency and 1099, according to him its should impact anything but after that he just gave me the credit agency's 1-800 number and told me to talk to my tax man. Blah! So much help.

2) Should I get all their promises and accurances in writing? Wonder if it will support my case should I get into some issue down the road with the credit agency?

Any thoughts?

Re: "Therefore they are willing to cut the second loan amount enough to cover the closing cost."
----and----
Re: "I don't have to bring forward any money towards closing. So to me it seems pretty clear that its a no closing cost."

Lets say the second loan is originally $50,000 and they cut it $2000 to cover costs.

Two things happen here...
1) The reduction in the loan amount of $2000 is a loan forgiveness and therefore taxable via a 1099 form as income.
2) You are still borrowing that $2000 as it will be added to your loan amount and disbursed at close to the lender to cover their closing costs.

Another possibility...

Lets say for example that the ultimate lender (wholesaler) is willing to pay the retail lender ( the person you are dealing with) 2% of the loan amount at interest rate 6.125% but will pay them 2.250% of the loan amount if you pay an interest rate of 6.375% . That 0.25% of the total loan amount is income that the retail lender can use to offset your closing costs. In this case, you "borrowed" the closing costs by paying 0.25% higher interest rate for the life of the loan on the whole loan amount.

Lets use an example.. Lets say you call several painters and one says, "I'll paint your house for free, all you have to do is pay me for the paint." Do you really think that the painter is going to charge the same amount for the paint as the current price at your favorite hardware store? Or visa versa offers to give you the paint for free if you just pay him his labor... Will that labor rate be the same rate as the other painters... or get billed for the same amount of time?

Unfortunately, since all costs get totally disclosed at closing time on the HUD-1 and it is the RARE borrower who even reads it let alone understand it, this practice while misleading, is totally legal. For the record, when I (as a loan officer) am faced with a client who calls and says... " Tom X offered me a no closing cost loan, why can't you?" My response... "If you pay the closing costs the rate is x%. If its a no closing cost loan, the rate is y% (where y is higher)... and the difference in monthly payments is...$z per month, it's your choice".

Back up a minute. Before anyone can give you any realistic advice you need to answer some questions:

(1) How much is the current balance on your first mortgage?
(2) How much is the current balance on your second mortgage?
(3) How much is the new loan amount going to be if you refinance?

Sandkicker and LisaB4657 I quickley wanted to thank both of you for your insight into my inquiry. Your responses has educated me and I feel I am confident in my decision. Once again thanks for your help.