Still No Free Lunches: Understanding the "No-Cost" Loan

There's no such thing as a free lunch, especially in the mortgage industry.

A reader at VA Loans Insider recently asked about so-called no-cost refinance loans. He had received some advertisements touting these painless mortgages and wanted to know if they're legitimate.

The reality is pretty simple: There's always a cost. Always.

It's more a matter of how and when you pay it.

How 'No-Cost' Really Works

Mortgage originators (banks and brokers, essentially) get a rebate for giving a borrower a higher interest rate on the loan. That rebate is called Yield Spread Premium.

Typically, one of those "no-cost" offers means you're getting a higher interest rate than you could probably obtain elsewhere. A higher rate means more Yield Spread Premium. The lender can then use some of the excess to cover closing costs and other fees and charges.

So, while that "no-cost" offer may limit your exposure at the outset, you'll ultimately pay more over the life of the loan by having a higher interest rate than what you might have secured elsewhere.

Here's a quick example to illustrate:

A 30-year, fixed-rate mortgage at $200,000 and 4.5 percent interest means a monthly mortgage payment (without taxes and insurance) of $1,013. Ratchet the rate up to 5 percent and the monthly payment jumps $60. That may not sound like a lot, but that's an extra $720 each year and a whopping $21,600 over the 30-year life of the loan.

Check the Numbers

Taking a higher interest rate to avoid up-front fees isn't always a bad thing. But given the lowest interest rates in years, this path isn't going to make a lot of sense for borrowers. Besides, VA borrowers often pay little to no out-of-pocket costs at closing. Even some VA refinance loans come with minimal costs and fees for our borrowers.

You can certainly explore the no-cost route, but be sure to get additional quotes and drill down into the numbers. Look at what you'll pay today, next year and over the life of the loan.

And remember there's no free lunch.