The Truth About "No Cost" Mortgage Loans

You've probably heard the pitch - "Refinance your existing mortgage with no points and no closing costs!  It's the biggest no-brainer in the history of Earth!"  But is it really?  Why would some lenders choose to charge closing costs if there's an alternative with zero closing costs?  The answer may surprise you.

Let's take a moment to discuss what closing costs actually are, and are not.  Closing costs are those charges that are external of the loan itself, but are required in order to obtain the loan.  In most cases, the fees are third party expenses, such as the appraisal, the legal fees, government recording fees, lender fees, and credit reports.  In other words, closing costs are not just a way for lenders to stick you for more money; they are third party expenses that are paid for services necessary for your loan to be processed, and by law, must be treated as pass through expenses - whatever is listed on the HUD as being paid to a third party must reflect the actual cost of the service performed.  Now this is not to say that some lenders don't try to take advantage by packing on "junk" fees to pump up their revenue.  But that's very different than the blanket statement that closing costs are rip-off.  In reality, there is no mortgage with zero closing costs; only mortgages where your closing costs are paid on your behalf.  Why is that an important distinction? 

The reason is that the people pushing the "No Closing Costs" mortgage want you to believe that because of their volume, or bargaining power, or out of the goodness of their heart, they've eliminated all of your closing costs.  The reality is, they've just changed how you pay them.  For example, compare the interest rate on a $250,000 mortgage with zero closing costs, to one with $2500 in closing costs (which would be typical in MA).  Generally speaking, you'll see a difference of .375% on the interest rate, which equates to approximately $61 per month in payment.  So in exchange for saving $2500 in closing costs, you agree to pay $61 more per month in payments.  Is that a good deal?  Maybe, maybe not - it depends on what happens next.

Let's say that you go with the higher payment, and elect to pay closing costs through higher payments.  This will turn out to be a good decision if you decide to refinance or sell within in a few years of opening the loan.  However, if you were to keep this mortgage for say 10 years (and many people that opt for this program are placed into 30 year fixed mortgages), you will have paid out $7320 in higher payments over those 10 years to save $2500 in closing costs.  Even if you were to invest that $2500 at 8% over 10 years, that investment would only grow to approximately $5300 in 10 years.  All in all, it doesn't look like a very sound decision.

Now, I'm not going to tell you that there's no Free Lunch, because you already know that.  What I am going to suggest to you is that when evaluating whether or not a No Closing Cost loan is the correct choice for you, make sure you compare the total package to a full closing cost loan, and then measure those costs over the time you expect to keep the mortgage.  I think you'll find that it's not the slam dunk the No Closing Cost guru's would have you believe!