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.


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