The Fallacy of No Cost Loans: Everything You Need to Know
Imagine being told you can buy a home without having to pay upfront fees—no appraisal fees, no underwriting, no title, or escrow, etc… It sounds pretty enticing, but more times than not no costs loans are a gimmick that banks have been using for years to trick clients to pay significantly more over time.
This guide will help you understand the reality of no-fee mortgage loans, often called "No costs" loans. While these loans eliminate the need for the client paying normal closing costs, they shift these fees into a higher interest rate over the entire loan that you’ll pay over time. By diving deeper, we’ll reveal the hidden costs and potential long-term impact, so you can decide if a cost mortgage is truly worth it, and then give you a step by step process to determine the whether a no cost loan is right for you.
"No Cost" loans sound straightforward. Here’s a quick breakdown:
During the course of a loan, there are roughly 50 parties that interact to process your loan. There are processors, loan officers, account executives, title officers, title reps, underwriters, internal processors, escrow officers, escrow first chair, and assistants, appraisers, funders, doc drawers, intake, disclosure specialists, and assistants all the way down the line, Obviously each of these people don’t work for free, and need to be paid. But where does the money come from, and is a no cost loan the best option?
Points: “points” are 1% of the loan amount. Thus if you have a $400,000 loan and are being charged “a point as a DISCOUNT”, then you’re being charged $4,000. A borrower can pay discount points upfront to reduce their interest rate over the loan term. In a "No Point" loan, the borrower avoids paying any points to get the selected rate. This is known as “par pricing”, or “parity”.
Discount Points: In this scenario the bank charges up front interest to buy down the rate.
Premium Pricing: Conversely, the client can also take a higher rate and get a “premium” paid back to them to help pay their closing costs.
No Fees: In a “no fee” loan, lenders cover standard fees—title, escrow, processing, appraisal, notary, etc…or closing costs.
While these features make "Cost" loans seem like a financially sound choice, they come with a huge hidden catch. A much higher interest rate, and higher interest paid to the bank over time.
To make up for waiving these upfront costs, lenders charge a higher interest rate, and then use the “premium” to pay all of or most of the closing costs. This can lead to a significant increase in the total cost over time. What’s worse, this increase in rate is not just to the closing costs, but the ENTIRE loan is now subject to the higher rate.
On a $600,000 loan, the difference between a no point loan and a loan where the client pays the closing costs is roughly 3/8 of a point higher in rate. This “small” difference in rate equates to over $52,000 difference in payments over the course of the loan. Granted you probably won’t have the same loan for 30 years, but you most likely have a mortgage for the next 30 years, so it only makes sense to minimize what you’re paying out to the bank.
This concept is further exasperated with smaller loans, as it takes a higher and higher percentage of the loan to fully cover all closing costs. Think in terms of “points”, which again, is equal to 1% of the loan amount. While the percentage is fixed daily (based upon market conditions), the loan amounts fluctuate between clients, which gives the bank the amount that they can give you back in dollars, based upon the loan amount. Thus, if you’re pricing at 1 point above par, an $800,000 loan will yield you $8,000, but a $200,000 will only yield you $2,000. If your closing costs are $5,000, the $200,000 loan will have to raise the interest rate to cover an additional 1.5% to get to the $5,000 mark. Thus, lower loan amounts inherently have higher interest rates on no cost loans.
While no-fee loans may feel like a way to save money, the reality is more complex. The "no-fee" structure translates into a higher interest rate and MORE MONEY BEING PAID TO THE BANK OVER A LONGER PERIOD OF TIME. In other words, you’re still paying for these costs—they’re just spread out across the life of the loan rather than being paid upfront.
In rare cases, when absolutely necessary, no point loans can be used to cover your closing costs, but again, this should be used sparingly.
Again, this benefit come with a huge trade-off. Choosing a no-fee loan is like deciding between paying for something outright or opting for a payment plan with interest. While the reduced upfront cost can be appealing, it’s crucial to understand the long-term implications.
DID YOU KNOW THAT A 0.5% DIFFENCE IN RATE ON A $500,000 LOAN EQUATES TO $58,000 OVER THE COARSE OF THE LOAN?
The real truth behind no-fee loans lies in the costs they conceal, which can lead to regret, frustration, and a sense of financial “trapping” as the months and years go by. Here’s what to consider:
1. Higher Interest Rate and Long-Term Costs
With a no-fee mortgage, the interest rate is higher to cover the costs that would otherwise be paid upfront. Over the life of the loan, this means paying thousands more in interest. This difference becomes particularly unsettling if you keep the loan for many years, as the cumulative cost can far exceed the original savings on fees.
Emotional Impact: Imagine realizing years later that a seemingly helpful option has cost you thousands more than expected. This realization can feel like a betrayal of your own financial judgment, leaving a lingering sense of regret.
2. Slower Equity Growth
A higher interest rate not only raises your monthly payments but also slows the rate at which you build equity in your home. With more of your payment going toward interest, it takes longer to gain ownership.
Emotional Impact: Watching your equity grow slowly can feel discouraging, especially if you hoped to leverage that equity for future plans. For those eager to build wealth or reinvest, the delayed growth can feel like a setback.
3. Less Favorable for Long-Term Borrowers
If you’re planning to stay in your home for a long time, the cumulative interest from a no-fee loan can be staggering. Over the years, the cost may far exceed what you would have paid with a standard mortgage.
Emotional Impact: Long-term borrowers often end up paying tens of thousands more in interest, which can feel like a financial trap. The weight of this added cost over time can be daunting, especially as it may limit your ability to save for other goals.
4. Higher Monthly Payments
The trade-off for eliminating upfront fees is a higher monthly payment, which can strain your budget. Higher payments leave you with less disposable income for other financial priorities.
Emotional Impact: Financial stress can be emotionally exhausting. Knowing that your monthly budget is tighter due to the higher payments from a no-fee loan can lead to frustration, regret, and even resentment toward the lender.
5. Limited Refinancing Options
Refinancing to a lower rate later might be more challenging with a no-fee loan. If market rates don’t drop or refinancing costs are high, you could be stuck with the higher rate.
Emotional Impact: Feeling “trapped” in a mortgage with limited options for refinancing can lead to frustration. The inability to switch to a more favorable loan structure can create a sense of lost financial control.
6. Opportunity Cost
Choosing a no-fee loan may mean passing up other loan options that could cost less in the long run. The missed chance to secure a lower-rate loan can be a tough pill to swallow.
Emotional Impact: Regret and frustration are common when borrowers realize they missed a better deal. Feeling like you “lost out” on a more cost-effective loan can impact your financial and emotional outlook for years.
In Chess, each piece of material is assigned a numeric value. Pawns are a point, Bishops and Knights are 3. Rooks are 5. Queens are 10 (9), and the King has an infinite value. The purpose of these valuations is to determine if trading two pieces (material) is worth it.
Is it worth trading your Bishop (3) for your opponents Rook (5)?
Based solely on value, the answer is “yes”.
When determining whether a no cost loan is right for you, you must look at the benefits, vs the cost.
Ask what the rate is on a no point, no fee loan.
Ask what the rate is where you’re paying the closing costs.
Once the payments are calculated at each rate, calculate the difference between each payment and multiply by the number of years that you’re comfortable with. If you’re just starting out, you’ll most likely have a mortgage for the next 30 years. If you’re close to paying off your home, you can truncate the amount of months that you’re using to calculate the difference.
I’d be remiss if I didn’t address this for you.
This is super important- more times than not, in a refinance, the closing costs can simply come out of the equity of your home, which is okay. This is far better than a higher interest rate. In other words, you don’t even need to materialize money for the “upfront fees”; it’s just added in to the total loan amount. As long as it doen’t change your LTV, then this is advisable. Again, would you rather pay $4,000 today, or $52,000 over the next 30 years?
However, if you’re planning to stay in your home long-term, want to build equity faster, or prefer the security of a lower interest rate, a standard mortgage with standard closing costs is a much wiser choice.
Before deciding on a no cost loan, take a look at the difference in payments over a specific amount of time and truly think if it’s financially beneficial to you. Take the time to evaluate all options. The mortgage industry is full of lousy offers. I’ve seen them over the last 22 years. Make sure you’re working with somebody who has a strong fiduciary ethic and is ALWAYS working in your best interest.
If you have any questions about anything written here, or have questions about your lenders practices, please feel free to reach out to me anytime.
Also, you can check out wholesale mortgage rates with my free mortgage rate calculator. No password, no phone number or email address needed. Just go the site and price out your loan.
Want to know more before you owe? You can always call me anytime.
Good luck.
Nick Vaccaro
858-217-5363
The Know Before You Owe Guy
Mortgage Expert
20+ years of experience
4,000+ loans closed