You may have seen advertisements about banks and mortgage brokers offering no-fee loans. The ad promises no closing costs. Sounds good, maybe too good….

The reality is a no-fee loan doesn’t make a whole lot of sense. There are costs that need to be accounted for. First off, you need an appraisal, a process done by an independent appraiser. Then there are credit report fees, flood certification fees and title searches to name a few that have to be paid by someone. Chances are the bank doesn’t want to eat those costs.

Banks can certainly waive their own application and origination fees, and they often do. However, there are very real expenses in processing a mortgage loan. Somebody is paying for those expenses. And if the bank is offering you a no-cost loan, it simply means the bank is absorbing those costs.

So what’s wrong with that? Let the banks deal with the costs; you’re bringing them business after all. Well the reality is, the bank plans on making a certain amount on each loan. And if they have to take a hit somewhere, they are probably looking to make it up somewhere else. In other words, the mortgage bank may have been willing to give you a lower rate if they didn’t have to absorb the closing costs.

It’s naïve to choose a lender simply because closing costs are less or zero, versus another lender who may be offering a lower rate. You have to consider the entire cost.

The APR is one simple way of evaluating your overall cost because it will include the rate, points and closing costs in providing you the actual pricing of the loan. But to get a real answer, let’s first understand what the fees are and then determine how to calculate the pricing of the loan.

1. The appraisal fee is charged by the appraiser. Depending on the size of the home, this cost can range from $300-$1,000.

2. Bank fees range anywhere from $500-$1,500. These are commonly referred to as origination, commitment or lock fees.

3. Miscellaneous fees including credit report, tax certification, flood certification and other fees total less than $100.

4. The major cost is the title search and insurance. That will likely run several thousand dollars and will depend on the actual mortgage amount. And unfortunately, even if you’ve financed in the last year, you still have to obtain new title (but the cost will be less than it was for the initial report).

There are three alternatives in paying these closing costs.

1. The first is to actually pay the funds at closing. If you intend to hold the loan for a long period of time, this is likely your best choice.

2. The second choice is to simply add the cost into the loan by increasing the loan amount by the amount of the costs. The negative of this is that you have increased your loan amount and you are now paying interest on those additional funds. Again, in the long run, this is also a better choice than the third option because it is not increasing your rate.

3. The third choice is to actually have the bank absorb the cost. Typically, the way that this will play out, is that the bank will raise the interest rate in order to offset the costs of the loan. On a $300,000 loan, the costs will be approximately $3,000. The amount of the increase to cover the costs will likely be approximately ¼ percent. This increase will enable the bank to give you a credit large enough to offset the closing costs. While this sounds enticing because you’re not laying out money for the closing costs and you’re not adding it to your principal, if you hold the loan for an extended period of time the higher interest rate could cost you much more than the closing costs.

In our example above, on a $300,000 loan, the closing costs are approximately $3,000. The additional cost of the increase of ¼ percent is approximately $540 each year, which means that after six years, you will have already paid $3,240 worth of incremental costs by choosing a no fee loan. So if you’re planning on selling the property/refinancing in less than six years, choice number three probably makes sense for you. However, if you plan on staying in the home it is probably worth considering options 1 or 2.

Remember, there’s no such thing as a free lunch. You can always negotiate with your bank and try to get them to cover as much of the costs as possible upfront, but the dollars are coming out of someone’s pocket, and, in the end, it’s likely to be yours.

David Siegel is a Home Lending Specialist with Citibank in its Englewood office. Siegel can be reached at david.siegel_citi.com or 201-419-1330.

By David Siegel