Is there truly such a thing as a “no-closing-cost loan”? Like most answers to mortgage or finance questions, the answer is, “It depends.” In addition, there is the more important question of whether a “no-closing-cost loan” will benefit you or not. I know, it’s confusing. After all, how could something that supposedly has “no cost” hurt you in the wallet?
The cold, hard truth is there is always a cost for something, and someone is going to pay it — the seller, the buyer, or some third party. There really is no “free lunch.” Mortgage loans are not exempt, and it is important to understand the mechanisms behind loans that do not assess direct closing costs.
Let’s take a closer look at how this works. Every mortgage company and bank needs to make a profit. That profit is used to pay salaries and keep the lights on, so to speak. Like any other “for profit” company, banks and other mortgage lenders make their profit from a product that they sell.
In this case, the product is the mortgage loan itself, which is sold to investors like Fannie Mae or Freddie Mac on the open market. The cost at which the loan is sold is directly tied to the interest rate; the higher the rate, the higher the price that can be charged for the loan. The goal of each lender is to provide as competitive a market rate to a customer as possible while still being able to sell that loan at a price that meets their profit requirements.
Asking a lender to provide you with the lowest interest rate possible, while also paying for your closing costs, is the same as asking the lender to lose money on your transaction. However, by slightly increasing the interest rate on the loan, the lender can create additional profit that can then be passed onto the customer as a lender credit toward their closing costs.
Here’s an example: Let’s say a borrower qualifies for a $300,000 mortgage loan with a market rate of 4.25% and closing costs of $3,000. The borrower requests a “no-closing-cost” loan. The lender requires a profit of $6,000 on this loan in order to cover all costs associated with the processing, underwriting, audits, and commissions being paid, as well as overhead.
By employing the strategy above, the lender can bump the interest rate to 4.5%, to create profit above & beyond $6,000. How? Because at 4.5%, the lender can sell the loan for around $9,000, and pass on the $3,000 to the borrower for closing costs, while still achieving their required profit margin. This mechanism is called “premium pricing” and is the most common way of providing a loan with no (or lower) closing costs.
Mortgage loans are not a “one size fits all” product; everyone has a different situation that depends on a multitude of factors. You now understand the primary mechanisms behind a no-closing-cost loan. Keep in mind that a no-closing-cost loan does not work for everyone, so it is critical to discuss your needs and financial goals with your mortgage loan officer.
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