A mortgage loan with no closing costs? It sounds like a great deal to most borrowers, but don’t be fooled: There are always fees associated with funding a mortgage, and someone has to pay them.
No-cost mortgage lenders will often advertise that they cover the fees themselves, or that the fees are waived entirely (it’s also up to the lender to decide which fees are “waived,” and which are still the responsibility of the borrower). However, fees on a loan don’t just go to the mortgage servicer; home closing costs include third-party expenses like appraisal, title search and additional inspections.
So of course, everyone involved in funding a mortgage needs to be paid for their services, and the truth is that the borrower is ultimately the one to pay these closing costs in one way or another.
How Mortgage Fees Are Paid on a No-Cost Loan
When a borrower obtains a no-cost mortgage, they’re not dodging fees at all, but simply spreading closing costs out over the loan so that no cash is needed up front. Below are the two scenarios that allow borrowers to delay — not avoid — paying fees on a “fee-free” home loan.
#1. Mortgage Fees Are Rolled Into the Loan Balance
Rather than paying mortgage fees at the time of closing, mortgage-related expenses can be added on to the loan balance instead. While it may be a relief to secure a mortgage without having to come up with thousands of dollars up front, adding these extra expenses to the mortgage balance means you still pay the fees — just over a long period of time — and with interest!
#2. A Higher Mortgage Rate Covers Home Closing Costs
The other option mortgage lenders can employ to recoup closing costs on a no-fee mortgage is charging a slightly higher interest rate.
For example, you may qualify for a $250,000 principal loan at a 30-year fixed rate of 3.50% APR. However, to “avoid” paying closing costs of say, $4,000, the lender bumps your rate up to 3.75% APR. This would increase payments from $1,123 to $1,158 according to this mortgage calculator, an addition of just $35 per month.
However, an extra $35 paid 12 times a year, over 30 years, totals $12,600 over the life of the loan — obviously, a better deal for the lender.
How Lenders Get Away With Calling it “No-Cost”
When asked how it’s possible for mortgage lenders to advertise loans in such a misleading way, Bill Westrom of TruthinEquity.com explained that because the borrower isn’t paying home closing costs directly, technically, the lender is footing the cost. “It’s a matter of syntax, really,” he says.
And though the Truth in Lending Act requires mortgage lenders to disclose all fees in writing, it’s ultimately up to the borrower to ensure they understand the specific terms of their loan. “Recent reforms have attempted to make the lending process more transparent for the consumer, but those reforms have nothing to do with educating the consumer,” Westrom adds.
So while the lender may be “paying” closing costs upon signing, those costs are put right back on the borrower in one way or another. It’s up to the borrower to find out how, exactly, that will affect their loan.
Avoid at All Costs?
Even though there’s no such thing as a no-cost mortgage, loans that are advertised as such aren’t always a bad deal. If you’re thinking about taking a higher interest rate to cover fees, determining whether paying more interest is worth no up-front costs is a matter of calculating your break-even point.
Financial advisor, David Donhoff, explains “a good financial rule of thumb is to remember that the ‘breakeven time period’ for dollars paid up front, versus delayed into interest charges, is around 3-5 years.” Borrowers planning to stay in their home for just a short period of time or refinance within a few years may very well come out ahead on a no-cost mortgage.
However, Donhoff continues, “if a consumer is highly confident they won’t want to refinance or sell after about five years, they get a financial advantage by taking the lower possible interest rates available by paying most or all of their closing costs in cash.” Calculate how many years it would take to pay off your closing costs at a higher mortgage rate. If you think you’ll keep your loan for less than that amount of time, you might actually save money on the deal.
However, when it comes to adding fees onto the mortgage balance instead, the borrower stands to receive no real savings. Even if you were to refinance shortly after securing a loan, you would still have the higher balance that includes original closing costs to pay off.
A no-cost mortgage rarely benefits the borrower, as is the case with most products backed by gimmicky marketing language. That’s not to say this type of mortgage can’t be used to your benefit. A good lender will be up front about the costs associated with obtaining a loan, and the options for how those costs can be paid, but it’s up to you to vet the source of your mortgage and ask the right questions when it comes to the terms of your loan.