Do No-Cost Mortgages Really Cost Nothing?

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The first option is to pay the associated fees—closing costs—at settlement. It is just another check you get to write when the deal closes. The second way is to get the seller to pay all the costs. What that really means, Holland says, is "the seller just increases the price of the house to cover the closing costs." So once again, you wind up paying for them—just indirectly. And since the costs become part of your mortgage, you are paying interest on them as long as you pay on your mortgage.

The third way to finance a mortgage loan is with a no-up-front-cost loan which, to add to the confusion, is sometimes referred to as a no-cost loan. With this type of loan, the costs get added to the amount borrowed and financed. So if you have to borrow $100,000 and the loan costs $5,000, you get a mortgage for $105,000. In other words, just like the loan costs the seller pays, the cost of the loan is added to the cost of the home, and you pay interest on it. The fourth way is the no-cost loan. "With this type, the lender actually pays all the costs of the loan," Holland explains, "but he/she is also charging you a higher interest rate."

The term "lender" can be confusing. There are usually two different "lenders" in a loan. Many people often refer to the agent or broker they deal with to get a loan as their lender—the person who processes and approves the loan. The second is the lending institution, the company that actually supplies the money. This is the real lender, since it is the source of the money. The lending institution makes its profit on the loan interest. Brokers and agents have their own operating expenses to meet. Generally they collect from both the lending institution and the borrower. So when we are talking about costs in a no-cost loan, we are actually referring to the costs that a mortgage broker or agent charges.

By the time you add in the loan origination fees, appraisal, inspection, escrow or legal fees, taxes and filing fees, these costs can add up to 5 or 6 percent of the total amount borrowed. "With no-cost loans," Holland adds, "you generally will pay a higher interest rate, and you usually have higher fees." With this type of loan, the lending institution pays the broker the fees so the borrower doesn't have to.

"If you are only going to live in the home for a couple of years, take advantage of a no-cost loan. I deal with a lot of people who plan to move in a few years. They take the loan and reduce their out-of-pocket expenses. If you are planning on being there for the long term, though, you want to lowest rate possible. You don't want the no-cost loan."

Let's see what that works out to in terms of monthly payments. We'll look at a standard, 30-year, $100,000 home loan. Now it doesn't really matter if that $100,000 represents the amount you have to borrow to pay for the home, or the home and closing costs; it's just a $100,000 loan. If you got it at 6 percent, your basic monthly payment—not counting taxes, insurance or assessments—would be $599.55. If, however, you were to get a no-cost loan at 6.5 percent, the basic monthly payment would be $632.07. That means that the no-cost portion of your loan is costing you $32.52 a month.

If you were to stay in that home and keep that loan for 24 months, your no-cost loan would cost you $780.48. For five years it would be $1,951.29. As noted before, costs associated with a loan can add up to 5 or 6 percent of the total amount borrowed—in this case $5,000 or $6,000. So less than $2,000 is a pretty good deal. But if you were to stay in your new home for 20 years, that no-cost loan would end up costing you $7,804.80.

There are other problems with having to pay a higher interest rate. Aside from having to come up with a little bit of extra money every month, your interest rate often limits how much you can borrow. Most people are approved for a monthly payment based on their credit history, income, debt, and other factors. If you were approved for a loan with a payment of no more than $600 a month, you would not qualify for a payment of $632 a month. In other words, while you could get a $100,000 loan at 6 percent, you could not afford a $100,000 mortgage at 6.5 percent. The most you could afford would be a loan for about $95,000. And as anyone who has ever gone house hunting will tell you, $5,000 can make a significant difference when you are looking at home prices.

So while the idea is having a no-cost loan is appealing, it does have its drawbacks. Keep in mind three ifs: 1) if you can qualify for that higher monthly payment, 2) if you are comfortable making it, and 3) if you are pretty sure that you will be out of that home—or that loan—before the extra interest you pay adds up to more than the loan actually costs. If you can do all three, it is definitely worth trying to get a no-cost loan. Just remember, everything hinges on how much the no-cost loan is really going to cost you.