I was recently asked this question online, and generally speaking - NO, it is not legal. While I will agree that it is practiced widely throughout the U.S., it is generally not legal, and should even be discouraged for several reasons.  Many times, it leads to other forms of fraud, such as inflated appraisals. Whenever a lender is not aware of all of the details of the transaction in writing, or the lender is not informed as to the true nature of the transaction, the transaction is illegal.

First of all, what buyer wouldn't be enticed by the notion of not only avoiding having to come up with cash for the closing costs, but actually receive cash in hand at closing - when most buyers are left nearly broke! Many new homeowners could really use the money towards paying off credit debt or home repairs and renovations.

And what mortgage officer or broker wouldn't be lured into the hope of a bigger commission check? Seems like a win/win situation, but there are actually loosers, and reasons that the government is actually regulating the cash-back scheme. Lenders could be tricked into making risky loan which they may otherwise have avoided. Buyers may end up owing more than they need to borrow, or worse yet, more than the property is worth. Many times the borrower is tricked into buying more house than they can afford.