At best, the “no cost loan” is a misnomer. At its worst, it’s misleading.
With a no cost loan, lenders usually do one of two things:
- Include your closing costs into your home loan amount. By “rolling” your closing costs into your loan, the cash required at closing would decrease, and your loan amount would increase accordingly.
- Increase the interest rate for your loan, to reduce your closing costs accordingly.
Rolling the costs into your loan is pretty straightforward, it’s a dollar-for-dollar shift into the loan balance. The more complex option is when a lender will increase the interest rate on your loan to make up for your lack of cash at the closing table. In doing this, they can sell your loan for a premium and collect their fee during the sale of the loan.
This increase in interest rate translates to a higher monthly payment for you, the borrower. It also leads to an increase in the total amount of interest paid over the life of the loan. It’s not a “no-cost” loan, you just end up paying your closing costs (plus some!) over a longer period of time instead of upfront with cash.
This allows the lender to recoup the fees when they sell the loan on the secondary market, making their profit from the investor instead of the borrower. From the investor perspective, the increase in interest rate has a significant impact on the lifetime value of the loan.
Depending on how long you keep the loan, this may or may not work in your favor. There is usually a break-even point for no-cost loans — on a certain month, the increased monthly payment will equal the amount you would have paid at closing. If you refinance a mortgage or sell the home before that point, you’ve saved money. If you go beyond that point, you have paid more than the closing costs amount.
A no cost loan is a viable option for many. It reduces the upfront cash required to buy, ultimately lowering a major barrier for homeownership. In today’s low interest rate environment, a “no-cost” loan can be a valuable tool as long as you understand the long-term implications.
There are also edge cases where a no cost loan can work in your favor. Say you have saved 11% of your home value. Instead of putting 8% down and paying 3% in fees, you may be better off with a no cost loan and increasing your down payment, but reducing the amount you pay in mortgage insurance.