It's hard to turn down a bargain. You've seen it on television: order in the next five minutes and get a free gift. Maybe you won't buy the latest gadget for $19.95, but if they throw in two gadgets, then how can you resist?
The mortgage industry is exactly the same, with one catch: the money involved is a lot more serious. After all, if you can really find a "no-cost" mortgage, you could save thousands. Especially with Internet-based lenders like Popular‘s (Nasdaq: BPOP) E-Loan and GMAC‘s (NYSE: GM) Ditech, you'll often see opportunities to get a new loan or refinance an existing loan with no out-of-pocket costs. However, free offers are rarely simple acts of kindness. With those TV offers, if a gadget costs $0.50 to make, the manufacturer can afford to give you two for the price of one and still make a big profit. Similarly, mortgage lenders offering no-cost mortgages aren't giving away their money. While free offers by themselves aren't necessarily bad, it's important for you to understand what you're getting into.
The costs of no-cost mortgages
Anyone who has ever taken out a mortgage loan to buy a home knows about all the fees that usually come with mortgages. Appraisal fees, processing fees, credit report fees, application fees, title insurance, recording fees — the list goes on and on. One by one, the fees aren't necessarily all that problematic. But $100 here and $250 there adds up pretty quickly.
Mortgage lenders know that coming up with cash at closing is difficult for many borrowers. In order to make their mortgages look more attractive, many lenders offer so-called "no-cost" mortgages that eliminate the need for borrowers to write a check to pay for all those fees.
Yet while this may seem like a great deal, don't get confused. Lenders aren't paying for those fees out of their own pockets. The most common way that lenders create no-cost mortgages is to charge you a higher interest rate than they otherwise would. By doing so, they give up money now in the hopes of recouping it later on.
It may surprise you how quickly no-cost mortgages can catch up to you. For instance, on a $200,000 30-year mortgage with a fixed rate of 6%, your monthly payment will be about $1,200. If you pay just a quarter of a percent more, the payment rises by about $30 per month. While that may seem like a pittance to save a thousand or two of upfront fees, that $30 will add up to $10,800 over the course of paying off your loan. And in some cases, you'll be paying a lot more than just an extra quarter percent. (Calculate your mortgage payments with one of our Foolish calculators.)
Where no-cost helps
When you see a no-cost mortgage, ask your lender about what exactly is free. If your lender will actually waive or reduce some of their fees, then you may well benefit greatly from their offer. Some lenders won't charge application fees or will cut their rates on credit checks or other miscellaneous charges if you ask. On the other hand, if your lender focuses on rolling costs into your loan or not having to pay for fees at closing, odds are good that you'll be paying in other ways.