What Is a No Closing Cost Loan?

Casey Fleming

As explained in the previous blog, the costs of your mortgage can be thought of as being in two different boxes. One is the cost of getting the loan, the other the cost of having the loan. Put another way, one is the cost of paying everyone who works on your loan for their services, and the other is paying for renting the investor’s money for the next 30 years.  But since you’ve heard a commercial for a “no closing cost loan.” how does that work if there are folks who are working (and presumably getting paid to do so) on your mortgage?

Bankers rent money
The interest you pay is the rent he earns

In its simplest form, the cost of renting the money for 30 years is your interest rate. If there were no one at the table but you and the investor, then what you pay is what the investor earns. The interest rate is the profit the investor makes renting you the money.

Stacks and stacks of money
You’ll pay back a lot over 30 years

Let’s say you want to borrow 15 stacks of money. In your mind, put 15 stacks of money on a table. But you have to pay rent – interest on the money – to the lender. Put another 15 stacks of money on the table, and that represents you payments over the next 30 years.

Remember this is just an example. You may pay back more, or less money than this example.

Now here’s where it gets interesting. Remember the other box from the last blog? There are lots of folks to pay for their services for putting you and the investor together, doing the due diligence, and assembling and underwriting the loan file. Imagine that there is another stack of money off to the side.

In a loan where you pay zero points but you pay your closing costs, you would pay the stack on the side now, and each of the other stacks every year until you paid off your loan.

Will work for latte
No need to pay us in cash!

But you just heard a commercial that said you could get a “no closing cost” loan! How does that work?

All of those people decided to work for fee! Ha ha! I’m kidding. It’s quite simple. The lender pays them on your behalf! Why would they be so generous? They’re not, of course. But they can raise the interest rate on the loan, making your payments higher, and get the money back that way. In essence, they charge a premium on the rent – the interest rate – to recoup the cost of paying for your costs up front.

So now you don’t pay in advance for the stack of money representing the loan origination costs, but you pay a little bit more in each of the other stacks in the form of a higher interest rate. You already know that if you finance anything you will pay more for it, don’t you? That is true with closing costs, too. The extra amount you need to pay every month for 30 years is much more than the amount you would pay if you paid it in advance. But, you can pay it over time.

This is how a no-closing-cost loan works. The investor pays for the costs out of their pocket, and charges you a higher interest rate to rent the money. You’re happy because you didn’t have to pay costs, and the investor is happy because they earn more in the long run. It comes out of your pocket, of course, but not for a few years. There are two lessons to take from this:

  1. If you intend to keep a loan for its full term, pay for your costs up front. You will save money in the long run.
  2. If you intend to keep the loan for only a short while take the higher interest rate and have the lender pay the costs.

Now let’s say you heard a commercial that claimed a lender had “no out-of-pocket costs!” How does that work?

Now instead of charging you a higher interest rate, the lender simply adds the costs to your principal balance. Your payments still go up, because now you’re paying back more money.

How is this different than taking a higher interest rate? It looks the same. In this example your interest rate is still low, but you owe more money to begin with. Over time you will pay back about the same amount of money as if you financed the closing costs in the interest rate, but because the principal balance starts out higher, we will always owe more money this way, until both loans are paid off.

There are three lessons to learn from this:

  1. College-level finance
    Any loan officer should know the math

    If you intend to keep the loan for only a short while, go back to financing it through the interest rate. If you finance it through a higher loan amount instead then when you pay off the loan you will probably owe more than if you financed it through the interest rate. This is not good.

  2. If you intend to keep a loan for its full term, pay for your costs up front. You will save money in the long run.
  3. However, if you must finance the costs, then compare the overall cost of the two options explained above before you do this. It’s just math, so it’s not that hard to calculate. If you’re not sure how to do it, ask your mortgage advisor. If you mortgage advisor can’t do it (and show you his math) then get another mortgage advisor.

There are two take-aways in these lessons:

  1. First, it costs money to originate your loan, and nobody works for free. Everyone who works on your loan gets paid, and you will pay for their work one way or another. There are strategies that help you pay less for it depending on your situation and goals, but there is no free lunch.  There is no “no closing cost” loan.
  2. Second, like anything else, a mortgage is more expensive if you finance it. If you plan to keep the loan for a long time and can pay cash for it, do it – you will save money. If you can’t pay cash for it, then make sure you calculate and compare the projected costs for each of the two options for financing the costs of the loan. If you will only keep the loan a short time, it’s almost always a better idea to finance the costs with a higher interest rate.

There is one more level to the question of up-front costs versus monthly payments that we haven’t covered yet, and that is whether to pay points or not. Please click here to learn all about points and how to use them to your advantage.

Casey Fleming, Author The Loan Guide: How to Get the Best Possible Mortgage (On Amazon)
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