Why we refinanced: 3 homeowners' stories (© Gregor Schuster/Getty Images)

© Gregor Schuster/Getty Images

If you're shopping for a mortgage, you've probably run into "no-fee" mortgages. They're also called "zero closing cost" or "no closing cost" mortgages. All of these phrases are downright misleading.

"There is no such thing as a free lunch or a free mortgage. Everybody involved finds a way to get paid," says David Donhoff, a mortgage broker with Leverage Planners in Kirkland, Wash.

No-fee mortgages are not, as the name implies, mortgages without fees. The term is misleading, says Richard Booth, a certified mortgage banker with America's First Funding Group in Neptune, N.J. "With all that has occurred in the lending world over the past several years, my industry needs to be doing it better and more transparently."

A no-fee mortgage lets a borrower finance some or all of the costs of getting the mortgage in exchange for a higher interest rate. Is it right for you? It depends on your situation. We'll show you how to decide.

Financing a home or refinancing a mortgage costs money. The charges vary, depending on where you live. They include the lender's fees (origination fees), which can be as much as $1,600, plus other costs: title insurance, an appraiser's service, taxes and insurance. (Here's the full list from the Federal Reserve. The fees can total $4,000 or more.

The options
Here's a summary of the three ways to pay the fees, with pros and cons: 

1. Pay in cash at closing. The simplest and often cheapest approach is to pull out your checkbook when you sign your mortgage contract and write a check to cover the costs.

  • Pros: If you have the cash, this may be best because you can avoid financing charges.
  • Cons: You'll need to produce several thousand dollars. Also, as you'll see in a minute, if you refinance again or sell soon, there's a chance you could save by not paying cash.

2. Add the fees to your loan amount. When lenders talk about "rolling in" your fees, this is what they mean. Say you're borrowing $180,000 to buy or refinance your home. The loan fees are $3,000. Roll them together and your new mortgage balance becomes $183,000. You repay the increased balance with interest on the entire amount.

  • Pros: No cash required. Spreading the fee across your monthly mortgage payments lets you soften the immediate financial impact of the mortgage purchase.
  • Cons: You're taking on extra debt, and the cost of financing that larger amount is worked into your monthly payment.

3. Pay a higher interest rate (no-fee option). You're financing your fees again, but instead of adding to the loan balance, you accept a slightly higher interest rate.

  • Pros: Your loan balance stays the same. The interest you pay on the fees qualifies under the federal income-tax mortgage deduction.
  • Cons: You pay a higher interest rate on the entire mortgage.

Shopping for choices
Is the no-fee option the smartest consumer decision? That was the question Marco Casalaina asked in August when he wanted to refinance the $338,000 mortgage on the San Francisco condo that he bought in 2010.

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Casalaina had been hearing about no-fee mortgages and was intrigued.

"I had a friend who had gotten a no-fee refinance for a low rate, so he got me into it. It wasn't an absolute requirement, but it was an idea I had in my head," he says.

He did some shopping. You can save by comparing offers because interest rates vary by as much as a percentage point for the same mortgage product, says David M. Harrison, a finance professor at Texas Tech University who teaches courses on real-estate finance and investment.

Here's an example: On a $400,000 mortgage, fixed at 3.5% over 30 years with a monthly payment of $1,796, your rate might rise, for example, to 3.625%, or to $1,824 a month — a $28 monthly difference — to cover $2,000 in loan fees, says Michael Moskowitz, president of Equity Now, a New York mortgage lender. "It's a simple trade. You get $28 more a month in your payment, but your lender is giving you $2,000 more on the $400,000 loan."

Casalaina got quotes from his bank and brokerage company and asked for detailed statements of the fees included with each. He also filled out the form on a lending website, resulting in a flood of phone calls from salespeople.

"Within the first 10 minutes, I got maybe three calls," he says.

He compared the interest rates on all the offers, with and without fees included. One, a "zero-fee" option from the online site, appeared substantially lower, even with all fees included in the rate. But there was a twist: The offer required a nonrefundable processing fee of $495.

He kept asking questions. The $495 would be applied to his loan fees if he went ahead with the loan, the lender told him.

"That was unusual. It really sketched me out a little bit," Casalaina says. What if he decided the loan wasn't for him? Would the loan broker keep the money? What if he paid it and the lender didn't follow through, or demanded a higher rate or more fees at the last minute?

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He read online reviews — some negative, others positive — written by consumers who had used that lender, including one from a borrower whose $495 fee was refunded. The lender was well-established, which helped him feel safe, and the rate offered was low enough, even with fees included, that he decided to take the chance. The transaction, while not yet finished, appears to be on track, he says.

Assessing the no-fee option
Comparing interest-rate quotes with and without fees included, as Casalaina did, is one way of deciding. You can refine the process even further, though, by figuring out how soon you'll pay off the fees with a no-fee loan.

The "break-even" date matters because it determines whether you'll end up ahead with a no-fee loan. Here's why: If you sell or refinance before your monthly payments have paid the fees, you're the winner. You got the loan more cheaply than you would have by paying the fees in cash.

But after the break-even point, this is no longer true, because you keep paying that extra interest.

On most no-fee refinances, the break-even point is between about three-and-a-half and five years, Donhoff says. Typically, a no-fee mortgage adds $40 to $100 a month to your mortgage payment, depending on the size of your loan, he says.

Moskowitz gives an illustration of how this works: Let's assume you get a $200,000 loan, fixed for 30 years at 4% interest with a monthly payment of $955. The loan fees are $2,000 if paid in cash. But if you choose a zero-fee option, the interest rate rises to 4.25% and the monthly payment to $983 — around $360 a year extra to cover the fees.

At $360 a year, it'll take you 71 months — around six years — to break even on the deal. If you sell or refinance before then, you're ahead. Even for a while afterward, if the slightly increased cost of financing is worth more to you than producing $2,000 in cash now, it's still a good deal.

But it becomes less of a good deal with every month that passes after the break-even point. By the time 10 years have rolled around, you'll have paid $3,600 for $2,000 worth of fees.

The average homeowner moves every five to seven years, says Mike Fratantoni, vice president of research for the Mortgage Bankers Association. As mortgage rates fall, people tend to refinance more frequently.

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First calculate the break-even point on no-fee loan offers and then ask yourself, "How long will I keep this loan?" Moskowitz says.

Richard Booth, a mortgage banker himself, did the math recently on refinance offers he was given and decided to pay his fees out of pocket.

Sometimes a "no-fee" mortgage includes all your fees, sometimes just a few. The quotes that Booth received included just bank fees and appraisal — worth $850 if paid in cash.

"The no-fee would have raised my monthly payment by $26.94, not a huge amount," Booth says. The extra cost might have been worth it if he expected to sell or refinance soon.

The break-even point for the fees was 31 months. But he'd have kept paying $26.94 extra each month for 27.5 more years — a total of $9,698.40 extra in interest charges for the no-fee option. 

But Booth plans to keep the mortgage and accelerate the payments to pay it off early. He lost a little tax benefit by paying cash, he concedes. But that didn't matter. "My goal for my particular situation is that I wanted the loan paid off in 15 years," he says.

Adding to your loan balance
The other way to finance your fees is to add them to the amount you borrow. If your mortgage is $200,000 and the loan fees are $2,000, your loan balance grows to $202,000. You pay interest on the higher balance. At first glance, the two options look similar. But there are differences.

Harrison sees no advantage to increasing a loan balance to pay fees. If you pay the fees with a higher interest rate, you'll get a larger home-mortgage-interest tax deduction than you would by adding to the loan balance, he says.

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"If you go with the higher interest rate and rates continue to decrease, you can always refinance that, whereas when you go with the higher balance, when you got to refinance, you're starting out with a new, higher balance.

"For most people," Harrison says, "the relevant comparison is a 'no-fee no points' loan versus paying a couple thousand in closing costs."