What Exactly Is A "No-Cost" Refinance?

You probably see ads all the time for “No-Cost Refinancing”, but what exactly is it and how do some lenders offer it and some don’t?  The truth is, all lenders can offer it and probably do, it’s just that some use it as a marketing gimmick. 

A true no-cost refinance is one in which the lender literally picks up all of the fees, with exception to your escrows (assuming you escrow taxes and insurance) and pro-rated interest.  So you don’t pay any fees; no appraisal, no credit report, no title search, nothing.

So how does the lender do it?  Understanding this requires knowing how lenders are compensated.  Most lenders are compensated by the banks and mortgage companies to whom they sell or broker loans.  Typical compensation for a lender who wants to be competitive is .75 – 1% of the loan amount.  This means that for a $200,000 loan, the lender would be paid $1500 – 2000 for originating the loan.  Each day, lenders receive rate sheets from all of the banks and mortgage companies showing what the compensation is at different rates.  So if at 6% the lender is getting paid 1%, then at 6.125% they would be paid approximately 1.5%, and at 6.25% they would be paid approximately 2%.  As you can see, the higher the rate at which they lock you, the more they are paid.

That is where the no-cost refinance comes in.  Whereas a traditional refinance involves a locked rate based on specific closing costs, the no-cost refinance is at a higher rate with no closing costs.  The lender actually quotes you a higher rate and uses the compensation to pay for the closing costs.  Using the example above, at 6.25% the lender is getting paid $4000 by the bank or mortgage company for originating your loan.  If the total closing costs are only $1600, the lender nets $2400 compensation from your loan, and you paid nothing to do it.  Or did you?

You see, you haven’t yet, but you will.  That’s because when you choose a no-cost refinance option, you’re getting a rate that is .25-.375% higher.  So you’re basically financing the closing costs in the interest rate, something that can add up over time.  Let’s take a look at an example.  The interest on a $200,000 loan at 6% = $1000/month and a $200,000 loan at 6.25% = $1041.67.  So the difference between the traditional refinance and the no-cost refinance is $41.67 higher each month.  That means that if closing costs run $1600, you would start losing on this option after 38 months, which is the break even ($1600/41.67=38.4).

So longer term a no-cost refinance may cost more, but in times where the Fed is cutting rates and they are expected to drop, you may want to choose this option as you can refinance over and over without trying to guess the bottom.

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