Some people may be aware of the term no cost mortgage, but in truth not many people know what it means and even fewer people understand the benefits and disadvantages of the scheme.

In essence a no cost mortgage is really a refinancing loan that is secured on a property, usually when there is sufficient equity in it. This new loan or mortgage is designed so that borrowers pay no fees upfront to obtain the mortgage. The catch that comes with a no cost mortgage however is that by not paying any up front fees the mortgage actually carries a higher interest rate, to compensate for this aspect of the loan. The no cost mortgage is therefore a no up front fees mortgage and not a free mortgage as some people may think; or dream.

A no-cost mortgage was an attractive option when interest rates on fixed-rate financing were under 6 percent. Now that rates are moving higher, paying points may make more sense, particularly if you're buying for the long-term. For example, let's say you're trading up to a home that you plan to own 20 years or so until your children are in college. You're financing the purchase with a $500,000 mortgage. For one point, the interest rate will be 6.25 percent with a monthly payment of $3,078.60. The zero-point option will cost 6.5 percent with a monthly payment of $3,160.35--a difference of $81.75 per month, or $918 per year. If you opt to pay one point, you will need to keep paying on the mortgage for approximately five years and two months to break even when compared to the cost of the no-point mortgage.

For most first-time buyers looking for long-term financing, a no-cost mortgage is generally not the best option. But there are those who can benefit. home buyers who would find it a struggle to cover the upfront charges on a mortgage may find it easier to have these expenses waived and just pay a bit more each month. And those who plan to move or refinance in a few years may also come out ahead, as long as there are no prepayment penalties. Remember, too, that no-cost mortgages may carry prepayment penalties to discourage you from refinancing as soon as you find a lower rate. Beware of additional charges. While a true no-cost mortgage really does waive many upfront fees, unscrupulous lenders may deceive borrowers by simply tacking fees onto the loan amount. For example, on a $150,000 mortgage, they may lure you in by requiring no cash on closing, but then add $2,500 in fees to your principal, so your mortgage is really $152,500. As a result, you will pay far more over the long run.