No-Cost Mortgages Can Actually Cost You More

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“There’s no such thing as a free lunch.”

Such words have never been more relevant to consumers being pitched no-cost mortgages, which offer borrowers the ability to pay no closing fees.

No-cost loans do provide the consumer another choice in world of mortgage financing. On the other hand, the fees associated with procuring these loans still need to be paid, and the cost comes in the form of a higher interest rate, costing the borrower more over the life of the loan.

Crunching the Numbers

Here’s how a no-cost loan works: The mortgage lender offers you a higher interest rate in exchange for providing you a credit to cover your closing costs.

For example, assuming a loan amount of $300,000 and closing costs of $2,600, the lender might offer you three distinct choices:

  1. 30-year fixed rate mortgage at 3.26 percent with 1 discount point (based on 1% of the loan amount) and you paying $2,600 in closing costs.
  2. 30-year fixed mortgage at 3.5% with no points and you paying the $2,600 in closing costs.
  3. 30-year fixed mortgage at 4%, no closing costs.

Comparing options 2 and 3, here’s how the math breaks down:

The 30-year fixed mortgage at 3.5% contains total interest paid over the life of the loan in the amount of $184,968, so the total cost of the mortgage (computed by adding the closing costs to the interest paid over the full term) is $187,568.

With the 30-year fixed rate no-cost option at 4%, the total interest over the full term of the loan comes to $215,609.

The total cost difference is $28,041, or about $85 per month.

So if the closing costs are $2,600, you would actually break even in about 30 months by paying the closing costs yourself and forgoing the no-cost option.

Length of Loan

Ultimately it boils down to how long you plan to keep the loan. (Notice that’s how long you keep the loan, not how long you keep the house.)

If you plan on keeping the loan for:

  • 3 years or less: A no-cost loan makes sense considering that you’re going to be paying off the loan anyway.
  • 5 to 7 years: A no-cost loan begins to look less attractive than its fee mortgage counterparts.
  • 10 years or longer: No-cost loans take a backseat to fee mortgages.

If you’re in the process of refinancing and qualifying for a mortgage is tight, then it might be beneficial to use a no-cost loan option. For example, if you have to pay down your principal balance to refinance your mortgage loan, a no-cost loan might make sense considering your cash assets would be going to the principal balance to reduce the amount financed.

Securing the lowest possible mortgage rate is on every consumer’s mind these days, but in order to achieve that, a no-cost option wouldn’t be suitable. To get the best possible interest rate and subsequently the lowest monthly mortgage payment, consider taking out a no-points mortgage loan or a loan containing discount points, so long as the interest rate is favorable.

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Scott Sheldon is a senior loan officer and consumer advocate based in Santa Rosa, California. Scott has been seen in Yahoo! Homes, CNN Money, Marketwatch and The Wall Street Journal. Connect with him at Sonoma County Mortgages.

Note: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinion or position of Zillow.