How a No Cost Refinance Loan Really Works

no cost loan

You may have seen or heard ads for a “no cost refinance” lately, a mortgage loan program that promises no fees or out-of-pocket expenses when you refinance your existing mortgage.

While this type of offer is by no means a new concept, or unique to any one lender, it’s definitely a subject worth visiting to ensure you understand what you’re getting when you choose this option.

What Is a No Cost Refinance?

no cost refinance

  • A mortgage refinance usually results in out-of-pocket costs
  • To account for things like lender fees and third-party services
  • A no cost version means you don’t pay these fees directly
  • But you might wind up with a higher mortgage rate as a result

A no cost refinance is essentially a loan transaction in which the lender or broker pays settlement costs.

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This includes typical lender fees such as processing and underwriting fees, the appraisal fee, and loan origination fees, along with third party costs like title/escrow fees and so on.

You may be asking yourself how banks and lenders make up for the absence of fees that normally must be paid during a refinance (or purchase) transaction.

Well, assuming the lender actually pays your closings costs, doing so will bump up your interest rate, sometimes substantially, in order to make up for the missing fees that are typically charged to the borrower at closing.

No Cost Loan  = Higher Mortgage Rate

  • The tradeoff for a home loan with no fees is a higher interest rate
  • It’s not a freebie (no one works for free)
  • Though it might be possible to get the best of both worlds
  • If you take the time to shop around with different lenders

It’s a simple trade – pay nothing now, but pay more over the life of the loan in the form of a higher mortgage rate. We’re talking higher monthly mortgage payments and more interest over the loan term.

For some borrowers, a no cost loan is a necessity because they don’t have the required funds on hand to pay all the fees at closing, but for others it’s simply a decision that will need to be made during the loan process.

Assuming you have the cash on hand to pay closing costs, do you want to hold onto your money, or would you rather obtain the lowest rate possible?

If you allow the bank to pay these costs for you, you won’t receive the lowest rate possible. But you might be happy to accept a slight rate increase and put your money to work someplace else, such as in a retirement account or other investment.

Pay Attention to the Terms of the Deal

  • Not all of these deals are created equal
  • Some may just cover lender fees like origination, underwriting, and processing
  • While others may also include third-party costs like title and appraisal
  • Find out exactly what the lender is paying on your behalf before you proceed

The terms of no cost loans will vary by lender. Some programs may cover ALL closing costs, while others may still charge you for certain third-party fees such as appraisal/inspection, title, escrow, and even mortgage points!

For example, if a bank advertises a “no lender fees loan,” they will still expect you to pay for all third-party fees, along with prepaid interest, and any property taxes and insurance required for an escrow account.

Be sure to pay attention to what fees are and are not covered to determine if it’s a good or bad deal.

Keep in mind that mortgage brokers can also set up a no cost loan for you, tacking on a lender credit to offset the fees typically associated with a home loan. This too will result in a higher interest rate.

Regardless of which path you choose, you can still attempt to negotiate a lower rate whether it’s no cost or no fee, like you would any other mortgage.

[How to Lower Your Closing Costs]

Let’s look at an example of a no cost refinance:

No cost refinance: 6.5% mortgage rate, NO fees.
Standard refinance: 6% mortgage rate, $7,500 in fees.

Imagine you’re able to qualify for a mortgage at an interest rate of 6% on a $500,000 loan, paying a point to the lender and another $2,500 in closing costs, totaling $7,500. While this may seem like a large upfront cost, the trade-off should be a lower interest rate.

With a typical no cost mortgage, you’ll cruise through the process without paying a dime at closing, but you may end up with an interest rate of 6.5% or higher for the very same loan.

Assuming you make the interest-only payment each month, you’ll pay an additional $200 a month, or roughly $2,400 more annually if you select the no cost option at an interest rate of 6.5%.

As you can see, it’s a case of pay less now, but a lot more over time.  You’re basically financing the costs you didn’t pay at closing, which will be more expensive in the long run.

Is a No Cost Refinance a Good Idea?

  • In general, it can make a lot of sense if you don’t keep the loan very long
  • As upfront closing costs usually take several years to recoup
  • So those who expect to sell their home or refinance again in a short period
  • May benefit from going the no cost refinance route

This is the point where you need to ask yourself what you plan to do with the property and the mortgage.

If you’re planning on moving or upgrading to a more expensive home in just a few years, or if you’re the type who refinances often, paying upfront costs for a lower interest rate will probably be a losing endeavor. For you, a no cost loan may actually be a good choice.

After all, there’s no reason you should pay for a lower interest rate if you’re only going to turn around and sell/refinance a few months/years later.  You’ll never realize the savings!

But if you plan to stay in the home for five or more years (or whenever the break-even point takes place), it could make sense to pay a little more upfront for future savings.

Why?  Well, that $200 discount each month might ease your budgeting woes in the future, and amount to some serious savings if you stick with the mortgage for the long haul.

Remember, no cost loans aren’t inherently good or bad. They aren’t a scam and they aren’t magic.  The money is either paid upfront or over time.

Their associated benefit or cost will really depend on your unique financial situation, what the fees are, and what the interest rate impact will be.

Make sure you do the math and compare options before signing on the dotted line.

Also watch out for banks that “bundle” your closing costs on top of your loan amount, increasing the size of your loan, effectively making it a “no-cash loan.”

Though you may avoid out-of-pocket expenses and upfront fees, these costs are not lender-paid, and the loan is not a true no cost loan.

You simply pay the fees over the life of the loan instead of at closing.  And you’re stuck with a higher loan amount to boot!  Not necessarily a great deal.

For the record, you can also get a no cost loan for a home purchase, though it might take a combination of a lender credit, a credit from your real estate agent, and seller concessions to make it all work.

Lastly, don’t forget to negotiate.  It might be best to first ask the lender what their best rate is, then tell them you want a no cost refinance option as well.

That way you can see what the difference is without showing your hand.  If you tell them right away that you want the loan at no cost, you may never know how low the rate could have been.

Read more: Buying down your interest rate.

Today's Mortgage Rates 3.50% APR