How a No Cost Refinance Loan Really Works

no cost loan

You may have seen ads for a “no cost refi” loan lately, a mortgage program that promises no fees or out-of-pocket expenses when you refinance your existing mortgage.

While this type of offer is by no means a new concept, it’s definitely a subject worth visiting to ensure people understand what they’re getting when they choose a no cost refinance option.

What Is a No Cost Refinance?

A no cost refinance is essentially a loan transaction in which the lender or broker pays settlement costs, including typical lender fees such as processing and underwriting fees, the appraisal fee, and loan origination points, along with third party costs like title/escrow fees and so on.

You may be asking yourself how banks and lenders make up for the absence of fees that normally must be paid during a refinance (or purchase) transaction.

Well, assuming the lender actually pays your closings costs, doing so will bump up your interest rate, sometimes dramatically, in order to make up for the missing fees that are typically charged at closing.

No Cost Loan  = Higher Mortgage Rate

It’s a simple trade – pay nothing now, but pay more over the life of the loan in the form of a higher mortgage rate.

For some borrowers, a no cost loan is a necessity because they don’t have the required funds to pay all the fees at closing, but for others it’s a decision that will need to be made during the loan process.

Keep in mind that mortgage brokers can also set up a no cost loan for you, adjusting their yield-spread premium (commission) to the point where they make enough money to offset the fees associated with the loan.  *This is now accomplished by using a lender credit.

Tip: The terms of no cost loans will vary by lender. Some programs may cover ALL closing costs, while others may still charge you for certain third-party fees such as appraisal/inspection, title, escrow, and even mortgage points!  Be sure to pay attention to what fees are and are not covered.

For example, if a bank advertises a “no lender fees loan,” they will expect you to pay for third-party fees, along with property taxes, prepaid interest, and insurance.  Regardless, you can still attempt to negotiate a lower rate whether it’s no cost or no fee.

[How to Lower Your Closing Costs.]

Let’s look at an example of a typical no cost refinance program:

No cost refinance: 6.5% mortgage rate, NO fees.
Standard refinance: 6% mortgage rate, $7,500 in fees.

Imagine you’re able to qualify for a mortgage at an interest rate of 6% on a $500,000 loan, paying a point to the lender and another $2,500 in closing costs, totaling $7,500. While this may seem like a large upfront cost, the trade-off should be a lower interest rate.

With a typical no cost mortgage, you’ll cruise through the process without paying a dime at closing, but you may end up with an interest rate of 6.5% or higher for the very same loan.

Assuming you make the interest-only payment each month, you’ll pay an additional $200 a month, or roughly $2,400 more annually if you select the no cost option at an interest rate of 6.5%.

As you can see, it’s a case of pay less now, but a lot more over time.  You’re basically financing the costs you didn’t pay at closing, which will be more expensive in the long run.

Is a No Cost Refinance a Good Idea?

This is the point where you need to ask yourself what you plan to do with the property and the mortgage.

If you’re planning on moving or upgrading to a more expensive home in just a few years, or if you’re the type who refinances often, paying upfront costs for a lower interest rate will probably be a losing endeavor. For you, a no cost loan may actually be a good choice.

After all, there’s no reason you should pay for a lower interest rate if you’re only going to turn around and sell/refinance a few months/years later.  You’ll never realize the savings!

But if you plan to stay in the home for five or more years (or whenever the break-even point takes place), it would make sense to pay a little more upfront for future savings.  Why?  Well, that $200 discount each month might ease your budgeting woes in the future, and amount to some serious savings if you stick with the mortgage for the long haul.

Remember, no cost loans aren’t inherently good or bad. They aren’t a scam and they aren’t magic.  The money is either paid upfront or over time.  Their associated benefit or cost will really depend on your unique financial situation, what the fees are, and what the interest rate impact will be.  Make sure you do the math and compare options before signing on the dotted line.

Also watch out for banks that “bundle” your closing costs on top of your loan amount, increasing the size of your loan, effectively making it a “no-cash loan.”

Though you may avoid out-of-pocket expenses and upfront fees, these costs are not lender-paid, and the loan is not a true no cost loan.  You simply pay the fees over the life of the loan instead of at closing.  And you’re stuck with a higher loan amount to boot!  Not necessarily a great deal.

For the record, you can also get a no cost loan for a home purchase, though it might take a combination of a lender credit, a credit from your real estate agent, and seller concessions to make it all work.

Lastly, don’t forget to negotiate.  It might be best to ask the lender what their best rate is, then tell them you want a no cost option as well.  That way you can see what the difference is without showing your hand.  If you tell them you want the loan at no cost, you may never know how low the rate could have been.

Read more: Buying down your interest rate.


29 Comments

  1. Nancy October 15, 2015 at 8:20 am -

    We have a 30 year loan with an interest rate of 4.25. 26 years left on the loan. Owe $40,000.00. Would a no cost refinancing be a good option?
    Thank you

  2. Colin Robertson October 15, 2015 at 8:26 am -

    Nancy,

    It depends what your goal is and what the new interest rate will be. You aren’t that deep into the loan so restarting it may not be an issue, though you’ll want to determine the savings based on how long you plan to keep the new loan.

  3. Anna October 15, 2015 at 2:03 pm -

    Hi, just spoke to the mortgage associate regarding “No cost refinancing”. Current balance is 150K at 5%, was offered 3.875% at no cost + third party fees paid by the bank but the balance will be approximately $152K due to payoff amount + escrow + 15days of Interest charge…is this real? What is the actual benefit to the bank?

  4. Colin Robertson October 20, 2015 at 2:37 pm -

    Anna,

    Banks can offer no cost loans because they still make money by selling and/or servicing the loans. It doesn’t matter what your current interest rate is as long as they can make money on the new loan. Keep in mind that if you pay those closing costs yourself the interest rate would likely be lower, such as 3.5% for example.

  5. Bob January 27, 2016 at 8:49 pm -

    Thinking about a cash out refinance. We owe $204,000 with 28yrs left on a 30 yr @ 4.25%. House is valued at $300,000. Would like to take $30,000 out with minimal out of pocket at closing. Am I dreaming? Thanks

  6. Colin Robertson January 28, 2016 at 10:05 am -

    Bob,

    Why would you be dreaming? The LTV with the cash out would still be below 80% based on your numbers, though your rate may not be much better than 4.25%. Could also explore a second mortgage (HELOC, etc.) if the rate on the first is worse.

  7. Amber February 3, 2016 at 2:00 pm -

    Question, please…

    I owe roughly $160K on my home. It is currently valued at $240K. I need roughly $35-40K for home improvements. One bank is offering a cash-out refi at 4.125% interest rate, but only giving me $25K due to closing costs. However, this option does keep my mortgage roughly the same as it is now. Another bank is a heloc loan at 5.24% & no closing costs. Which is the better deal?

  8. Colin Robertson February 3, 2016 at 2:51 pm -

    Amber,

    It depends how long it will take you to pay back the loan, but you could probably get a first mortgage at a lower rate than 5.24% with no closing costs if they’re offering you 4.125% with closing costs. But you also have to consider the fact that if you refinance the first mortgage it resets the clock and interest is paid over a new 30-year term.

  9. Josh February 8, 2016 at 1:17 pm -

    I owe 450k at 4.25%. A broker is offering 3.75% with $3300 lender’s credit to pay of all closing costs (about $2900) which are listed on the HUD-1. There is also a 1.25% YSP to the broker by the lender. This deal not only saves me money (about $200/month) but also costs nothing out of pocket. It also gives me the option to not have an impound account which I really want. Anything I’m missing or overseeing? Or am I being ripped off by the broker? I don’t know what my par rate is.

    Broker says the lender’s credit will be shown once the loan is closed and not on initial disclosures which makes me a bit nervous. Is this how it is usually done?

  10. Colin Robertson February 8, 2016 at 2:19 pm -

    Josh,

    You could ask what the par rate is if you were to pay the closing costs yourself to see how low the rate could be. The loan also technically resets the amortization period if it’s the same term. And the lender credit should be on the Loan Estimate form.

  11. Micah February 16, 2016 at 3:50 pm -

    My draw period is up in 3 months. Interest only payment on a cash-out will go from 370 to P&I of 1000/month(loan balance of 112k) Mortgage pymt is 800(loan balance of 90K). That extra 600/month will hurt a bit… refi fees are steep and its a condo/TH so will a no-cost refi benefit me? I plan on staying here for the long haul also. Please help. Average selling prices have been in the 250-260k range as of late. Thank you in advance.

  12. Colin Robertson February 16, 2016 at 5:01 pm -

    Micah,

    Chances are you can consolidate both loans into one and ideally get a good rate at 80% LTV or lower. Not sure what your current rate is on the first/second but rates are super low again. And yes you can ask about doing it with no cost for a slightly higher rate and no/limited out-of-pocket costs, but you plan to stay for a long time it might make sense to go for a lower rate and pay the closing costs. The fact that it’s a condo/townhouse shouldn’t have much effect on the rate, possibly none if you can get the LTV down to 75%.

  13. Lynn February 25, 2016 at 3:12 pm -

    My husband and I are in the process of purchasing a house through a short sale. A family member is gifting us the money to purchase it since it is a cash sale only. We will need to pay the family member back within 1 year.

    I’ve been told in 10 months we should start looking into refinancing cash out loan. We would not have to put the 20% down providing the house appraises for more than the purchase price. And we will only get 80% of the appraised value.
    Am I understanding this correctly or is there something I am missing?

  14. Colin Robertson February 25, 2016 at 4:06 pm -

    Lynn,

    It would rely on home prices rising enough to appraise at the value you need/want…meaning there’s no absolute guarantee since no one knows with certainty where home prices will be in the future.

  15. Faith May 3, 2016 at 11:02 pm -

    I refinanced a VA loan, at no cost to me, last winter. My current interest rate is 3.5%. I keep getting flyers about very low interest rates. The new Loan Estimates and Closing Disclosures are harder to read than the old Truth-in-Lending HUD forms! There was a mistake when I closed on the VA IRRL (Interest rate reduction loan) with regard to the settlement agent information not being correct so I have two Closing Disclosures (the first one with the error and the second, corrected one) that show an $1170 increase from the Loan Estimate to the Final in the line on page 3 that says “Down Payment / Funds from Borrower.” I did not pay a down payment to do the IRRL. There is some type of scam going on but I am not smart enough to see it.

  16. Colin Robertson May 4, 2016 at 2:36 pm -

    Faith,

    If you have a 30-year fixed, 3.5% is a seemingly great rate…it doesn’t get much lower. Not sure what the $1170 is for…could ask your loan officer to explain.

  17. Byron June 7, 2016 at 9:36 am -

    I currently have a 3.5% IR on a VA Loan which I just found out I can have reduced to a 3.25% IR. There are no fees or closing costs with the refi and they say that I will save $40K in interest and $59 on the monthly note. We have $193,375 remaining on the loan. The thing is we never readjusted our original loan payment so we have been paying $145 every month to the principal, which we would add the $59 and just continue the course (along with bi-weekly payments to get the extra payment a year). So is this quarter reduction worth it? My other half is apprehensive because following the first refi we had to pay taxes. Your thoughts?

  18. Colin Robertson June 7, 2016 at 3:18 pm -

    Byron,

    The refi will restart the loan, which could be a negative if your goal is to pay it off in full and it’s already been paid for several years. And a quarter percent isn’t a very big drop in rate. Have you considered a shorter loan term if you’re currently on a 30-year? The rate would be lower, monthly payment higher, but interest savings also higher (and paid off faster obviously). Ultimately you have to compare total costs of both loans side-by-side to get the entire picture and determine which is best for your situation. Make sure that $40k figure is accurate and factors in your current special payment setup that you mentioned. Not sure what taxes you’re referring to.

  19. Michael June 9, 2016 at 1:29 pm -

    Interesting post. I think the main thing you left out was the benefit of no cost refi’s when it helps reduce your mortgage rate. I’ve been in the industry awhile and have been don’t these types of refinancing for my clients to help them reduce their rate upwords of 2%. Those closing costs can be hefty but if it helps save borrowers $200/month, why wouldn’t you refinance?

  20. MARC HAINES June 12, 2016 at 5:35 am -

    Colin
    We were in the midst of closing last week, and the day before closing the deal fell through (buyer couldn’t fund). I am moved out in an apartment in one state, my wife is an an apartment back by the house.
    We now have three monthly payments; we are still selling, and are seeing great market interest in the house, so would it be prudent (if our goal is to sell in the next 2-3 months) to ‘no-cost’ refi to lower our monthly obligations?
    Thanks kindly

  21. Colin Robertson June 24, 2016 at 3:45 pm -

    Michael,

    Sure it can benefit the borrower and still be no cost, I just like to point out that there is indeed a cost, and the rate could be even lower.

  22. Colin Robertson June 24, 2016 at 4:01 pm -

    Marc,

    Lenders would likely frown upon this if your intention isn’t to occupy the property for more than a month or two. It could also get hairy if you do wind up finding a buyer right away, or if the lender sees that you recently listed the home (on MLS records) and denies the refinance request on that basis.

  23. Mike August 20, 2016 at 4:13 pm -

    Would you recommend refinancing if have a 103k balance at 4.5% and will pay off in 3 years. Thinking we will pay about 8000 in interest over that time and any savings off that in refinancing would be negated by refinance fees?
    Thanks

  24. Colin Robertson August 22, 2016 at 7:35 pm -

    Mike,

    Well, if you’re able to do it at no cost and snag a lower rate and thus save money on payments each month without incurring any out-of-pocket costs it could make sense. Paying fees that won’t be recouped in three years might not be wise.

  25. April August 29, 2016 at 5:28 pm -

    Hi Colin,

    Thanks for the article. I am looking at a no cost refi right now but I learned as I was going through the paperwork that like you said, the cost is bundled in there; in my case it’s into the loan. We currently owe $342k and have an interest rate of 4.125% on a 30-year loan that matures on 2/1/2042. We are considering a 15-year fixed refi with a cash out for remodeling and are being told we could get around a 3% rate. I was told we only had to cover the appraisal fee but I see fees like credit report, tax service fee, underwriting, title charges etc totaling over $4518 that will be paid from the loan amount, but I do also see a lender credit of $1500. Our monthly mortgage payment will go up significantly, but we wanted to pay our mortgage off earlier, thus the move from 30 year to 15 year. Bottom line though, are we making a smart decision if we plan on doing a remodel and plan to stay for the long term? Should we look into paying the costs upfront to see if we could even get a lower rate? Thank you in advance!

  26. Mac September 14, 2016 at 7:54 am -

    Would a no cost benefit me if I am refinancing to a 15yr mortgage from a 30yr.

  27. Colin Robertson September 19, 2016 at 8:23 am -

    Mac,

    It definitely could, though my assumption is most folks looking to switch from a 30-yr to a 15 would seek the lowest rate possible, which would generally mean paying for closing costs. But it’s possible to find a lender with a lower rate than others and no fees if you shop around.

  28. Rob September 21, 2016 at 1:03 pm -

    Hi Colin,

    This is a great article – thanks for the informative words! Mortgages are exceptionally complex to me and I get buried in the math and jargon.

    I bought a $375K house two years ago with an 80/20 loan (due to minimum equity on the loan) and am looking to lower rates with a no-cost option as well as consolidate the loan. Appraiser rated the house at $395K, so we’re still not close to 20% equity yet but no escrow is a requirement for us, given we can make 15% floor through an employee stock purchase program vs letting it make nothing for us in an escrow account.

    Current offer on the table reduces rates on both primary and secondary loan rates with ~$2600 in closing costs rolled into the loan. My wife and I don’t plan to be in the house long enough for the math to work out long-term, but the lower payments month-to-month are attractive.

    I usually think if a deal is too good to be true, it usually is, but I don’t see any downside except for a couple thousand I’ll make up in 21 months or so. What am I missing? Thanks in advance!!

  29. Colin Robertson September 21, 2016 at 1:26 pm -

    Rob,

    There’s no real catch…it’s really just based on how long you keep the mortgage. Put simply, it makes sense to pay for a rate if you keep said rate for a long enough time to recoup the cost and save monthly. And vice versa. So those not keeping their mortgages long term usually don’t benefit from paying upfront.

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