You’ve heard the term “no free lunch.” Well, the same is true of home loans. There is no “free mortgage.”
Sure, banks and lenders will offer deals that make it look that way. They’ll give you a mortgage without closing costs. Or without points.
But that doesn’t mean it’s free. At the end of the day, everything has a cost.
It’s simply how you pay for it that changes. And in the mortgage world, you’ve got options.
You can accept a higher mortgage rate and pay nothing out-of-pocket. Or save each month via a lower interest rate instead.
Zero Origination Fee Doesn’t Mean Free Mortgage
First things first. A zero origination fee doesn’t mean your mortgage is free. It just means the bank, lender, or mortgage broker isn’t charging an origination fee.
An origination fee is an upfront fee that is charged to the borrower to provide compensation to the originator.
Some mortgage companies charge it, others don’t. However, those that do not can still (and likely will) earn a commission a different way.
Remember, nobody is taking time out of their day to help you get a mortgage without making money.
That would be nice, but that’s just not how life works. And why shouldn’t someone get paid?
If they’re helping you apply for and fund your home loan, they should be compensated. It’s actually hard work.
Lender-Paid Compensation on Mortgages
Many mortgage brokers get paid via lender-paid compensation. This means the lender pays them instead of the borrower.
For the record, borrower-paid compensation is also an option. But it’s typically not the option chosen.
Why? Because most borrowers would rather not pay a mortgage company or broker thousands of dollars out-of-pocket.
So they opt for lender-paid instead. The way this works is simple. The lender has a rate sheet with slightly higher mortgage rates that factor in this compensation.
For example, the borrower might be quoted a 30-year fixed rate of 6.5% with no fees whatsoever. It’s not a free mortgage.
It’s a mortgage that has the fees built in. The higher interest rate covers the fees that would normally be paid by the borrower upfront.
And instead of paying upfront, you pay over time. How? Via the higher interest rate.
If you paid closing costs upfront and commission out-of-pocket, your mortgage rate might have been 6% or lower.
A Free Mortgage Example
|$450,000 Loan Amount||Not-Free Mortgage||Free Mortgage|
|Total Upfront Cost||$6,750||$0|
|Monthly P&I Payment||$2,697.98||$2,844.31|
Now let’s compare those two options. The no cost mortgage with a 6.5% rate, and the 6% rate with out-of-pocket costs.
The monthly payment on a $450,000 loan amount at 6% is $2,697.98 on a 30-year fixed mortgage.
It’s $2,844.31 on the same loan at the higher 6.5% rate. That’s a difference of $146.33.
Does that mean the mortgage with no fees is free? Or does it mean you have you pay nearly $150 extra each month?
Similar to the no free lunch analogy, there’s always a cost. It’s just how/when it’s paid, not if it’s paid.
However, that doesn’t necessarily mean one is a better or worse deal. You’ve got to do the math and decide.
A Free Mortgage Can Be a Better or Worse Deal
Now to determine if free is better than not free. At least when speaking of upfront costs.
Remember, the free mortgage is about $150 extra per month. But we need to consider the closing costs on the not-free mortgage.
If our hypothetical borrower got the 6% rate, they had to pay lender fees at closing. And third party fees too, such as escrow, title insurance, appraisal, etc.
Let’s pretend they paid 1% in commission to the loan originator and another $2,250 in closing costs. That’s $6,750.
So while they’ll save about $150 per month, they’re “in the hole” $6,750 versus the free mortgage borrower.
But each month, they’ll dig themselves out of that hole. This happens via a lower payment and less interest paid. Lower-rate mortgages result in less interest. And more paid toward principal.
In order to get in the black, or pay off those upfront costs, it would take about 40 months of mortgage payments.
After that, the 6% mortgage rate holder is winning. They’ve paid off the closing costs and are saving each month thereafter.
It Depends How Long You Keep Your Mortgage, and What Happens to Rates in the Meantime
As you can see, time is a big factor in the free vs. not-free mortgage equation. The borrower who opts for the not-free mortgage must keep the mortgage for a while.
If they don’t, they leave money on the table. They never fully realize the monthly savings paid for at closing.
This means if they sell or refinance the mortgage, they don’t win. At least in terms of those closing costs they paid for.
So you need a plan when you take out a mortgage. Think about how long you expect to keep the house. And perhaps the mortgage too.
But note that mortgage rates are subject to change. They can even change daily.
If you pay closing costs out of pocket AND discount points today for an even lower rate, it might not work out.
You might find that 30-year fixed rates are back below 5%. And whatever you paid will be gone if/when you refinance to that new lower rate.
So the free mortgage gives you a little bit of insurance policy. It’s not as cheap monthly, but you can refinance at will if rates improve. You can also sell your home at will.
Oh, and you can pay it off early too to reduce the interest expense as well.