Focusing solely on your mortgage rate distracts you from the real cost of the loan — and it can be an expensive mistake.
That’s because the lowest interest rate doesn’t always translate to the best loan offer.
All borrowers must pay closing costs typically ranging from 3% to 6% of the loan. These fees can make or break the deal you think you’re getting on the interest rate.
The best deal hinges on how long you keep your loan. A low mortgage rate seems attractive when you calculate the savings over 30 years. But the reality is, the number of borrowers who keep a loan for 30 years is “virtually zero,” says Laurie Goodman, a former vice president for housing finance policy at the Urban Institute, a nonprofit think tank.
An option often overlooked by borrowers is a no-cost loan. It means accepting a higher interest rate in exchange for no closing costs, and it can often leave you with more cash in your pocket. By saving on upfront closing fees, cash is freed up to put toward other financial goals, such as investing for financial independence or paying off debts.
Mortgage rates have been rising to prepandemic levels and housing prices continue to reach record-highs This makes no-cost loans especially appealing right now because they can help reduce upfront costs — keeping more cash in your pocket or more cash to use towards a higher down payment.
Here’s what you need to know about no-cost loans.
How A Higher Mortgage Rate Can Save You Money
When presented with a no-cost loan or a low rate with closing costs option, it can be difficult to tell which one is best for you. On the surface, an interest rate appears to be the only money-saving factor of home financing.
Here is how the two loan types compare on a 30-year, $300,000 loan:
|Out-of-Pocket Closing Fees||Interest Rate||Monthly Payment||Total Interest & Fees|
|Loan A (Low Rate + Closing Costs)||$9,000||3.9%||$1,415||$218,400|
|Loan B (No-cost loan)||$0||4.3%||$1,482||$234,459|
In this example above, Loan A will save the borrower $67 per month and $16,000 total on interest by choosing Loan A over Loan B. But, that is only if they keep that loan for 30 years. The savings in this example are calculated over the full 30 years of the loan. Focusing solely on the interest rate prevents prospective borrowers from noticing another big number: Loan A’s $9,000 out-of-pocket closing costs.
With Loan B, a no-cost mortgage, the lender covers the loan fees with lender credits and the borrower accepts a higher rate. The borrower has $9,000 cash leftover in their pocket, which they could invest (and then earn compounding interest), use to cover move-in costs (and therefore avoid high-APR credit card balances), or put aside in savings or emergency fund.
Closing the Gap
Rising rates and housing prices are making it increasingly difficult for potential homebuyers to access homeownership. According to a 2022 analysis from the National Association of Realtors and Realtor.com, Black Americans are particularly affected. The study cites that about half of all currently listed homes are affordable to households with at least $100,000 household income. Yet only 20% of Black households have incomes greater than $100,000 compared to 35% of White households. For those struggling with accessing homeownership due to lack of down payment and closing costs savings, a no-cost loan could work in your favor.
Many Borrowers Won’t Keep a Loan As Long As They Think
The mortgage interest rate alone doesn’t tell the whole story, says Gordon Miller, president of North Carolina-based mortgage broker, Miller Lending Group. Especially since borrowers can pay to get whatever rate they want, he said. When you opt to pay closing costs upfront in order to keep your rate as low as possible, “you’re paying today for a benefit you’re never going to receive,” Miller says.
A typical borrower keeps a loan for less than 5 years, according to a 2016 study published in the Journal of Financial Economics. After evaluating over 300,000 home loans in the study, researchers found that “borrowers overestimate how long they will stay with the mortgage.”
With that in mind, instead of looking at how the loan plays out over 30 years, let’s look at what Loan A and Loan B (from above) would cost you in interest earlier in the mortgage’s lifetime.
Here is how the two loan types compare on a 30-year, $300,000 loan over three, five, 10, 15, 20, and 30 years:
*Total Cost Over:
|3 Years||5 Years||10 Years||15 Years||20 Years||30 Years|
|Loan A (Low Rate + Closing Costs)||$59,940||$93,900||$178,800||$263,700||$348,600||$518,400|
|Loan B (Higher Rate + No Closing Costs)||$53,445||$89,076||$178,153||$267,229||$356,306||$534,459|
What this table shows is that Loan A does not become a clear winner until year 15 of the loan. Holding Loan B from year 1 through year 10 is actually cheaper overall, even with the higher rate — if you clear the mortgage (refinance, payoff, or move) before year 10. That is because the closing costs associated with Loan A take a long time to actualize the savings.
The big question to ask yourself when choosing a mortgage is, how long do you plan to stay with this loan? If you are certain a refinance or move will take place in under 10 years, a no-cost loan could be a better financial fit.
No-Cost Loans Are Easier to Understand
When you eliminate your closing costs with lender credits, understanding the loan terms and comparing it to other no-cost loan offers is easier. This is because you only have to look at one number – the interest rate. You also won’t have to factor in the closing costs and whether or not you break even before your next refinance.
Lenders have an incentive to keep costs low when you’re not paying for the fees. “There’s no reason for them to pad things because it comes out of their pocket,” Andrew Pizor, staff attorney with the National Consumer Law Center in Washington, D.C. told NextAdvisor.
There are two different types of mortgages that are commonly referred to as no-cost loans:
- The lender gives you credit to cover your closing fees in exchange for a higher rate.
- The closing fees are added to the loan balance.
When you ask for a no-cost mortgage quote, be sure you know which options you are offered.
No-Cost Loans Can Give You More Options With Your Money
When you don’t have to pay closing costs on a mortgage, it increases your financial flexibility. Here are other options for the money that would have gone to closing costs.
With the extra cash on hand you can work toward all sorts of goals. Imagine if you invested $9,000 in a low-fee index fund with an average annual return of 7%. A compound interest calculator shows a $9,000 investment, without making any additional contributions, would earn nearly $3,000 in interest over five years. That means your $9,000 could grow to $12,016 in the same amount of time most homebuyers stay in their house (five years). If you kept the initial $9,000 invested for 25 years, you’d have $38,174.
Pay More Toward the Loan Principal
If your goal is to pay off your mortgage as quickly as possible, you could use the money that would have gone toward closing costs and instead use it to pay down your loan balance.
You can do this in two ways: Make extra payments towards the principal each month. Or put the money slated for closing costs towards a larger down payment.
Having an emergency fund can be a lifeline for any unexpected hardship: Income-loss, home repair, medical bills, or car issues, to name a few. Using a no-cost mortgage allows borrowers to hold onto the funds that would have gone towards closing costs and stay liquid in the event of a financial emergency.
How to Choose the Best Mortgage for Your Situation
Landing on a final mortgage offer comes down to each borrower’s personal circumstances and financial goals.
To help you understand how to find the best home loan for you, whether you are looking to refinance or purchase, you can compare lender offers using this Home Loan Comparison Calculator. You can enter in the loan amount, rate, fees, and term for each offer and see a true side-by-side comparison. This comparison tool will show you each loan cost over time to help you decide which loan can work best for you.
Home loan comparison calculator
Compare your payment options side-by-side to see which is right for you and your financial situation.
Find the mortgage that’s best for you by comparing the cost of multiple loans over time.
Why It’s Important To Shop Around
No matter what mortgage you end up choosing, getting quotes from multiple mortgage lenders is essential to finding the best deal for you.
The amount your interest rate will increase when you receive lender credits isn’t a fixed percentage. “You have to actually look at how much higher your interest rate is going to be, which is going to vary from time to time. It’s not going to be a constant number,” Goodman says. When you’re comparing no-cost loans, the math for your specific loan options could look different than the above examples, which makes it important to run the number for yourself using a home loan comparison tool.
Getting multiple loan quotes could save you an average of $1,500 to $3,000 over the life of the loan, according to research by Freddie Mac.