To anyone shopping for a home loan, a “no-cost mortgage” is bound to seem like a great deal. Closing costs (typically around 3 to 5 percent of the loan amount) can run into the thousands of dollars on even a modest mortgage. Who wouldn’t want to avoid them?
But like all things that sound too good to be true, no-cost mortgages are somewhat of an illusion. All loans have costs associated with them. The difference is simply that with a “no-cost” mortgage, the lender’s upfront fees are waived, with the trade-off coming in a higher interest rate. That means you save now, but can end up paying much more in the long-run.
Comparing a no-cost and a conventional mortgage
Assume you’re looking for a $150,000 mortgage with a 30-year fixed rate:
- Lender A offers a conventional loan at 7 percent with fees of $2,500.
- Lender B offers a no-cost mortgage with a rate of 7.5 percent.
So with lender A you pay $2,500 more upfront, but with lender B your monthly payment is $52 higher ($1,050 rather than $998).
In four years the costs would even out:
After 48 months of paying that extra $52, you would exceed the $2,500 you originally saved. If you stay put for five or six years, you will pay much more with the no-cost option. On the other hand, if you move or refinance after three years, you may save money.
Be sure to include all fees
The above example assumes that all the other mortgage terms are identical, and that the $2,500 is the only upfront cost involved. In the real world, things aren’t so simple. Not all expenses associated with closing are waived in a no-cost mortgage. Chances are you won’t be charged for processing fees and third-party costs such as the appraisal and credit report, but you will most likely still have to pay government taxes, homeowner’s insurance and any funds required for escrow. Make sure you understand exactly what is exempt and what is not when comparing a no-cost option with a conventional loan.
Check the rules
Remember, too, that no-cost mortgages may carry prepayment penalties to discourage you from refinancing as soon as you find a lower rate. In the example above, refinancing within three years may not save you money after all if you are required to pay a penalty (such as six months’ interest or a percentage of the outstanding principal).
Beware of additional charges
While a true no-cost mortgage really does waive many upfront fees, unscrupulous lenders may deceive borrowers by simply tacking fees onto the loan amount. For example, on a $150,000 mortgage, they may lure you in by requiring no cash on closing, but then add $2,500 in fees to your principal, so your mortgage is really $152,500. As a result, you will pay far more over the long run.
Who is likely to benefit?
For most first-time buyers looking for long-term financing, a no-cost mortgage is generally not the best option. But there are those who can benefit. Homebuyers who would find it a struggle to cover the upfront charges on a mortgage may find it easier to have these expenses waived and just pay a bit more each month. And those who plan to move or refinance in a few years may also come out ahead, as long as there are no prepayment penalties.
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