“There’s no such thing as a free lunch.”

Such words have never been more relevant to consumers being pitched to take out a no-cost loan. No-cost mortgage mortgages have been around since the mid-90s and offer consumers the ability to pay no closing fees.

The general closing costs you’d otherwise pay in procuring a loan are paid for by the lender at the close of escrow. These include any lender fees, appraisal fees, processing fees, title insurance fees, escrow fees and recording fees. The loan contains no fees at the close of escrow or financed in the loan. In fact, no-cost mortgages are going to soon become another mandatory disclosure lenders are going to have to show consumers.

Just last week on CNN Money, Richard Cordray, director of the Consumer Financial Protection Bureau, had the following words to offer on the upcoming new lender disclosures, “Consumers have a hard time comparing loans when they are dealing with a bewildering array of points and fees. We want to provide consumers with clearer options and enable them to choose the loan they believe is right for them.”

No-cost loans do provide the consumer another choice unique in the world of mortgage finance.

On the other hand, the fees associated with procuring that loan need to be paid by someone, and the cost comes in the form of a…drum roll please …a higher interest rate. The no-cost loan contains a higher rate of interest over term of the loan.
Guess who pays the extra interest?

Yep, you got it– the consumer.

No-cost mortgages are inherently costlier, than their “fee mortgage” counterparts. The fact of the matter is no-cost mortgages cost more, and consumers must understand these loans contain an inflated interest rate.

How a no-cost loan works
The mortgage lender offers you a higher interest rate over the term of the loan in exchange for providing you a dollar credit to cover your closing costs at the close of escrow. For example looking at a loan amount of $300,000, the closing costs are $2,600. The lender credit is $2,600. The lender might offer you three distinct choices:

• 30 year fixed-rate mortgage at 3.5% with one discount point (based on 1% of the loan amount) and you paying $2,600 closing costs;

• 30 year fixed-rate mortgage at 3.75% with no points, with you paying the $2,600 closing costs;

• 30 year fixed rate mortgage at 4.25%, no-cost to you.

Comparing Option 3 to Option 2, here’s how the math breaks down:

• Option 2 – The 30-year, fixed-rate mortgage at 3.75 percent contains total interest paid over the life of the loan in the amount of $200,164.84, so the total cost of the mortgage (computed by adding the closing costs to the interest paid over the full term) is $202,764.84.

• Option 3 – The 30-year, fixed rate no-cost option at 4.25 percent since the closing costs are paid with the inflated interest rate. We only look at the total interest over the full term of the loan. In this case, that amount over 360 months comes to $231,295.08.
The total cost difference is $28,530.24, or on a monthly basis it’s an extra $80 per month to have the lender pay the closing costs for you. So if the closing costs are $2600, you would actually break even in 32.5 months by paying the closing costs yourself and forgoing the no-cost option.

What it boils down to, is how long you plan to keep the loan. Notice how we recommend how long you keep the loan for and not how long you keep the house for. If you plan on keeping the loan for:

• Three years or less – a no-cost loan makes sense considering you’re going to be paying off the loan anyway;
• Five-seven years – a no-cost loan begins to look less attractive to its fee mortgage counterparts

• 10 years or longer – no-cost loans take a backseat to fee mortgages.

Other circumstances where no-cost loans can be beneficial:
• If you are in the process of refinancing and qualifying for mortgage is tight, perhaps due to assets or loan to value. For example, if you have to pay down your principal balance to refinance your mortgage loan, a no-cost loan might make sense considering your cash assets would be going to the principal balance to reduce the amount financed.

• Shorter-term loans such as five-, seven- and 10-year arms might make sense for the right client type for no-fee loans.

Mortgage tip: because mortgage rates change daily, the spread between a no-points mortgage loan choice and a no-cost loan choice can be anywhere between .5-1 percent in interest rate.

The larger the spread between the two loan choice options, the higher the total cost of the loan over time.
Another underlining theme on every consumer’s mind today is securing the lowest possible Sonoma County mortgage rate. In order to achieve that, a no-cost option wouldn’t be suitable.

To get the best possible interest rate and subsequently lowest monthly mortgage payment, consider taking out a no-points mortgage loan or loan containing discount points as long as the interest rate is favorable.

If you are seeking a Sonoma County refinance or any other type of home loan, we can provide you with clarity on the loan choices available so you can decide the most suitable loan program for your needs. Begin today by getting a mortgage interest rate quote. Learn why a no-cost mortgage still costs.

Scott Sheldon is a local mortgage lender, with over six years of experience helping people purchase and refinance primary residences, second homes and investment properties. Visit him at www.sonomacountymortgages.com.