Dear Lender, Why Does my “No Cost” Mortgage cost $8,774.33?

by Tony Abate · December 10, 2013

Any smart consumer knows that the adage “no free lunch” applies to almost everything in life. Acquiring a mortgage is no exception. However, one doesn’t have to go very far to find very exciting ads shouting “NO CLOSING COSTS!!” Who wouldn’t be intrigued by such a message? After all, obtaining a mortgage is expensive. Quotes from lenders for a typical $200,000 mortgage will reflect $2,000 to $3,000 in total closing costs, so “no closing costs” sure sounds appealing. So what’s the catch? There really isn’t a “catch” per se, but a consumer certainly needs to stay informed on how all of this works.

A no cost loan is all about the lender’s “cost of money” on any particular day. People often call & ask “what is the rate today?” The answer is that there is no one “rate” on any given day. For example, a lender might determine that they could offer 4.50% on a 30 year fixed rate loan, given the cost of money on that day. They could also offer a lower rate of 4.25% on that same day, but this would obviously be a less profitable loan. To compensate for that, they could charge the borrower a “point” (1% of a loan amount) at the time of closing to offset the lower profit. Going the opposite direction, they could also offer a higher rate of 4.75%. Since this a more profitable loan, the lender might (should) offer a credit back to the borrower, & for the sake of simplicity, let’s also say that this would be a “one point” credit.

All of this is the genesis of a “no cost” loan. Let’s look at the above example: if a borrower wanted a mortgage of $200,00, the lender might quote 4.5% with closing costs of $2,000. They might also offer 4.75% with “no closing costs”. Using the above, the lender has simply taken that one point credit of $2,000 (provided by the higher rate), & spent it on the closing cost. In short, the borrower pays no closing costs in exchange for a higher rate. Has the lender done something bad, sneaky, or wrong? Not if the consumer knows the facts, & equally important, has some view into the future. Take a look at the chart below:

Interest Rate	4.50%	4.75%
Loan Amount	$200,000.00	$200,000.00
Monthly Loan Payment	$1,013.37	$1,043.29
Interest for Life of Loan	$164,813.83	$175,588.16
Closing Costs	$2,000.00	$0.00
Total Loan Cost	$166,813.83	$175,588.16

This chart illustrates the total cost of both loan scenarios. Although the higher rate rewards the borrower with “no closing costs”, the overall cost is $8,774.33 higher with this”no cost” choice. One key observation here is the assumption that the loan will stay in place for the full 30 year lifespan. In truth, this rarely happens. Folks sell their homes, refinance, or do other things that would terminate the loan ahead of schedule. This is where that “view into the future” becomes relevant. If one is going to have the mortgage for the long haul, then the lower interest rate is the better choice. If the loan will be short-lived, then the “no cost” choice could serve the borrower better. Any good loan officer should be able to provide a consumer with a side by side analysis such as the one above. This actually allows a “break even” analysis to be performed. In the illustration above, 5.5 years is the magical “breakpoint”. If the borrower carries the 4.75% loan for greater than 5.5 years, then the greater interest expense would outweigh the benefit of “no closing costs”.

In then end, neither choice is automatically “better”, as the best choice depends upon one’s own financial situation. However, it is important to look at how a “no cost” loan becomes a “no cost” loan. Stay educated…no free lunches!