Free Mortgage Loan Costs, Myth or Real?

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A friend of mine who is also in the mortgage industry had one of his clients proudly tell him that she had never paid any closing fees on any mortgage loan she had ever gotten. I couldn’t help but smile over the lady’s excessive self-confidence because she in fact has paid closing costs on every single loan. In fact, she may have paid closing costs and then some when you really crunch the numbers. Let me explain.

A “No Fee” Mortgage Is Not a “No Cost” Loan

First, a key point to understand is that every mortgage loan has closing costs. The lender always has to hire out title, escrow, credit reports, appraisals, etc. Lenders can’t avoid these costs – after all, they’re essential for getting the loan done – they can only decide whether or not to pass them on to the borrower. If they choose to absorb the costs instead of charge the borrower for them, then they need to make up for these expenses another way.

So how exactly does a no-fee mortgage loan work? If the bank always incurs expenses to do the loan, how can they possibly stay in business by offering no fee loans? The short answer is that if they don’t pass the fees on to the borrower, they will charge a higher interest rate to make up for them. Is this necessarily a bad thing? It depends!

Fees or No Fees, That is the Question!

One of the first questions I always ask my clients is how long they want to keep the loan. If they’re planning to keep the loan only a few years, it’s usually better to go for a no cost loan even though the interest rate will be a little higher. If they’re going to be in the loan long term, taking a lower rate even though they’re paying the closing costs can often be a better option. The following example shows how this works.

Let’s assume I have a client who wants to refinance his $400,000 loan into a new 30-year fixed loan at current rates (which we’ll assume are around 5% for this example). I want to figure out what will provide the most benefit based on his financial goals, so I run a couple of different 30-fixed scenarios, as follows:

    * The “No Fee” Option: $400,000 loan amount, 5.5% interest rate, no closing costs, and a payment of $2,271.16.
    * The Low Rate Option: 5% with 1 point (1 point is 1% of the loan amount) and $2,500 in closing costs. The total for the point and closing costs is $6,500, so the new loan amount is is $406,500 (the closing costs are rolled into the loan). The payment for this option is $2,182.1.

Note that the “no fee” option has a higher rate. Again, closing costs are still being incurred by the bank, they’re just not being passed on to the borrower. The bank still needs to recoup them, however, so they charge a higher interest rate on the loan.

Because my client wants to keep the loan long-term, he opts for the low rate option with closing costs. Why? Let’s run the numbers and find out.

At the end of five years, the 5.5% “no fee” loan will have accrued $106,111.77 in interest. The 5% low rate option will have accrued $97,714.59 in interest charges – a difference of nearly $8,400. At the five year point, the low rate option with closing costs is already a better deal by nearly $2,000.

If we fast forward to the 10-year mark, the 5.5% loan will have accrued a total of $202,702.68 in interest and the 5% loan will have accrued $186,017.08 in interest charges – a difference of over $16,000. From this point on, the lower rate option with closing costs will save the client significantly over the no closing option.

As you can see, as long as the borrower keeps the loan at least five years, the lower rate option is clearly the better deal despite the closing costs. However, if he gets rid of the loan within the first five years, it’s probably a money loser for him.


Again, to recap, there are always closing costs on a mortgage loan, it’s just a matter of who pays them. If you’re refinancing and thinking short term for the new loan, it probably makes sense to take a higher rate and let your lender cover the costs. If you’re thinking long term, it might make more sense to pay the costs and go with a lower rate. Be sure to have your loan officer run several different options with or without closing costs so you can determine which option is going to make the most sense for you.

By now it should be clear that my friend’s client, who proudly proclaimed she’s never paid closing costs, has definitely paid closing costs – and possibly many times over if she kept her loans a long time. If she only kept her loans a few years, it might have worked out OK for her, but if she kept the loans for five years or longer, the higher rate might have cost her a lot more money in the long run.



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