It is awfully nice of lenders to be offering free loans. At least, that's what it sounds like they're doing. Think of all of the radio and television ads you have heard where the lender claims to be offering loans with no out-of-pocket costs. Have you ever wondered how they can do this? If they are not charging you, the money has to come from somewhere. It helps to clear things up when you understand how a loan officer makes their money.

Pay Now or Pay Later
Loan officers get paid in a way that they call "on the front" and/or "on the back." If a loan officer makes money on the front, that means they are charging for things that you can see. This money is either out-of-pocket or is incorporated into the loan when you sign the papers. These are things like processing fees and other miscellaneous charges that are charged for processing your loan. If a loan officer makes money on the back, that means money is being received from the bank as a sort of commission for filing the loan. This is the money you do not see. (To learn more about loan expenses, read our related article How To Read Loan And Credit Card Agreements.)

When lenders claim to be giving you a "no out-of-pocket" or "no-fee" loan, they are still making money, but they are charging it on "the back." Although the bank is paying the loan officer this money now, it is really coming from you the borrower in the form of a higher interest rate. Lenders that are not charging fees on the front can be charging a higher rate to make up for lost fees. In fact, the bank could be making a lot more money this way as they are getting a higher rate of interest for possibly 30 years or more. (Learn how interest rates affect change in the housing market, and how you can keep up, in How Will Your Mortgage Rate?)

Comparing Loans
How do you compare loans to be sure which deal is the best for you? You need to understand something called the annual percentage rate (APR). When you apply for a loan, the loan officer must give you a good faith estimate. On that estimate, you can find the APR. The APR shows the entire cost of the loan to you on a yearly basis. It factors in what the fees cost as well as the interest rate. By comparing good faith estimates and their APRs, you can get a better idea of what they are charging you.

So is that loan really free? As they say, there is no such thing as a free lunch. You might not be paying money out-of-pocket right now, but either you pay now or your pay later. Many times it is a better deal to pay the fees now to get a lower rate instead of paying a higher rate over 30 years.

What the Loan Officer is Thinking
Remember, loan officers are sales people; they get paid by selling you something. In this case, they are selling you the loan. If they are telling you it is a good time to refinance, you need to figure out how much that loan is going to cost you. To do this, you must consider how many out-of-pocket fees you will be paying, if the loan interest rate is less and if you'll be in the loan long enough to recoup these expenses. If you are getting a lower interest rate and not paying fees, it could be a better deal than what you have now. In that case, the no-fee loan could be a good idea. (Read The True Economics Of Refinancing A Mortgage to learn more about this concept.)

Be careful of the loan officer who wants to keep selling you adjustable rate mortgage (ARM) after ARM after ARM for the same property. ARMs are a good loan choice for certain people, especially those who know they won't be in their home or loan for very long. If you are planning to stay in your home a long time, an ARM may not be a very good choice. Loan officers receive money for every loan they make. Therefore, it behooves them to make as many loans as possible. One way to do this is to get people into ARMs that need to be refinanced often. (To learn more about the dangers of adjustable rate mortgages, read This ARM Has Teeth.)

Broker or Bank?
Not everyone agrees on this. Having worked for both, I can tell you that there are good and bad brokers, and bankers. The advantage of using a broker is that they can shop around at the different banks for the lowest rates. The advantage of using a bank directly is that they don't have to pay the broker. If the broker can find a lower rate, charge the broker fee, and still offer the lowest total rate, then that may be your best choice. You will have to do your homework and compare good faith estimates to be sure. Remember, the loan officer decides how much money they want to make to some extent; they may have some negotiating room. Don't always expect that brokers are giving you the best rate that they can. They may not be telling you the lowest rate they can offer because by offering the rate they quoted, they may be getting more commission on the back. (Read Score A Cheap Mortgage to learn more about getting the best rate.)

Do Your Homework
Though many loans given by loan officers/banks during the subprime meltdown of 2007/08 ended in foreclosure, you don't need to be that concerned, not if you do your homework. One of the biggest problems came with letting the lending requirements get too lax. Banks were granting loans to people that they used to deny. Something called the stated loan became more common. People were able to "state" how much money they made instead of having to prove it. Many people stated more than they actually made. Also, underwriters were under pressure to approve loans that may not have made sense because they were in competition with other banks that were approving these loans. Remember, it is all sales in the end.

How do you protect yourself? Do your homework. Shop around. Do not accept the first good faith estimate. Get several estimates. Compare the APR on each one. Go to both brokers and bankers to see what they offer. Be wary of the loan officer that doesn't ask you how long you will be living in your home. If they don't ask you questions, they don't know which loan fits you the best. If you are planning to only be in your home a short time, you might consider an ARM. If you are going to be there for a long time, consider a 30-year loan. Even better, if the day comes and you can afford it, pay extra each month on your 30-year loan and pay it off in 15 years!

Related Articles
  1. Options & Futures

    Payday Loans Don't Pay

    Hold too tightly to this rescue line and you'll soon be drowning in debt.
  2. Investing Basics

    Subprime Lending: Helping Hand Or Underhanded?

    These loans can spell disaster for borrowers, but that doesn't mean they should be condemned.
  3. Options & Futures

    Subprime Is Often Subpar

    Proceed with caution when considering these short-term, high-interest mortgages.
  4. Insurance

    What is a Force Majeure?

    A force majeure clause frees both parties in a contract from fulfilling their obligations in the event of some catastrophic or unexpected occurrence.
  5. Credit & Loans

    Explaining Equated Monthly Installments

    An equated monthly installment is a fixed payment a borrower makes to a lender on the same date of each month.
  6. Investing Basics

    Tiny House Movement: Making Market Opportunities

    The tiny house movement throws all assumptions about household budgeting and mortgage management out the window, and creates new market segments too.
  7. Investing

    Where Should I Keep My Down Payment Savings?

    While saving up for a down payment, where should you keep your money. A bank? The stock market? It all depends on your timeline.
  8. Credit & Loans

    Questions To Ask Your Mortgage Lender

    When buying a house, avoid nasty surprises by asking the right questions about your mortgage lender's qualifications and the mortgage process.
  9. Credit & Loans

    Bad Credit? You Can Still Get a Home Equity Loan

    If your credit history is less than stellar and you need cash, you may be able to get financing – but it will come at a price.
  10. Home & Auto

    5 Ways to Pay Down Your Mortgage - Without Going Broke

    Following these tips can help you reduce the length of your mortgage and save you thousands of dollars.
  1. What is the difference between "closed end credit" and a "line of credit?"

    Depending on the need, an individual or business may take out a form of credit that is either open- or closed-ended. While ... Read Full Answer >>
  2. In what instances does a business use closed end credit?

    The most common types of closed-end credit used by both businesses and individuals are mortgages and auto loans. Businesses ... Read Full Answer >>
  3. What are the long-term effects of delinquent accounts?

    Delinquency occurs when borrowers fail to make payments on their loans. All loan borrowers should do their best to avoid ... Read Full Answer >>
  4. How was the American Dream impacted by the housing market collapse in 2008?

    The American Dream was seriously damaged by the housing market collapse in 2008. In many ways, the American Dream is a self-fulfilling ... Read Full Answer >>
  5. How much risk is associated with subprime mortgages?

    A large amount of risk is associated with subprime mortgages. Since the mortgages are specifically for people who do not ... Read Full Answer >>
  6. What are the financial consequences of filing for bankruptcy?

    The financial consequences of filing for bankruptcy are substantial and can be long-lasting. They include impacts on your ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!