Because home buying is a complex, multi-step process that requires you to make dozens of decisions (large and small), and pay a variety of fees (also large and small), it’s easy to forget about the closing costs.
At that point, you’ll be presented with a bill that can range from 3-6% of the mortgage loan, not including fees for services such as the appraisal, title search, deed recording, etc.
For a mortgage of $200,000, the origination and third-party fees cost an average of $2,084.
If you can think of better uses for that money, or you simply don’t have that kind of cash lying around, don’t worry – most lenders can waive this upfront fee with a no-closing cost mortgage.
If used wisely, a no-closing-cost mortgage could save you thousands of dollars.
But in some cases, this type of mortgage could cost you thousands – or even tens of thousands – of dollars more than a mortgage that includes upfront closing costs.
Here’s how to exploit the pros and avoid the cons of a no-closing-cost mortgage.
A Temporarily Discounted Lunch
To start, never forget the adage, “There’s no such thing as a free lunch.”
This saying dates to the 19th century, when saloonkeepers would offer free lunches to anyone who bought drink.
Obviously, the lunch wasn’t actually free, since the patron had to buy a drink to qualify.
The same principle applies to no-closing-cost mortgages. In most instances, you will cover some of the closing costs … eventually.
Typically, no-closing-cost mortgages come in two forms:
- The lender simply adds the closing costs to the mortgage principal, which allows you to spread out the closing-cost payments over the life of the loan. The drawback to this type of no-closing-cost mortgage is that your monthly payments will be higher than if you’d paid the closing costs upfront.
- The lender will eliminate the closing costs entirely, but charge you a slightly higher interest rate for the loan, whether it’s an original mortgage or a refinancing. For example, the lender might offer you a rate of 3.5% if you pay the closing costs upfront, or a rate of 3.95% if you don’t. In the second scenario, the lender will usually recoup the closing costs – over the long haul – because of the higher interest rate.
The key word in the last sentence is “usually.”
A Short-Term Strategy for Borrowers
A no-closing-cost mortgage can save you money, but only if you sell the house or refinance the mortgage within a few years.
If you stay in the house too long (without refinancing), the higher interest rate – or the higher principal from folding closing costs into the mortgage – will make the loan more expensive than if you’d paid the closing costs upfront.
If you want to use a no-closing-cost mortgage as a money-saving tool, you first need to determine your “break-even point” – the number of months it would take you to recoup the closing costs from a standard mortgage.
To calculate the break-even point, use one of the many calculators available online. You can also ask prospective lenders to provide an analysis of the closing costs, as well as the difference in interest rates and payments for a no-closing-cost loan versus loans with upfront fees.
Once you identify your break-even point, you can compare that number to a no-closing-cost mortgage to determine a “timeframe of savings.”
For example, let’s say you have two choices for a $150,000 mortgage. One loan has an interest rate of 3.75% with $3,500 in closing costs, and the other offers a rate of 4.25%, with no closing costs.
Choosing the higher-rate, no-closing-cost mortgage would cost you an additional $43.24 a month – or nearly $16,000 – over the course of 30 years.
On the other hand, if you choose the standard mortgage with upfront closing costs, you would break even after six years and nine months.
In this case, you would only save “real money” by selling the house or refinancing to a new mortgage well before the deadline of six years and nine months.
Should You Risk It?
Because a no-closing-cost mortgage with a higher interest rate without the closing costs incorporated into the balance will lower your monthly payments, it could be a good option for someone who is temporarily cash poor or wants the extra money for projects such as home improvements and maintenance.
In that case, just be aware that you are making a tradeoff – lower monthly payments in exchange for a loan that’s more expensive in the long run.
For most borrowers, it’s probably best to opt for a standard mortgage product.
Unless you don’t have enough money to pay the upfront closing costs, or you’re certain to be refinancing or selling the house in a couple of years, a no-closing-cost mortgage could be the most expensive “free lunch” you ever eat.
Once in a blue moon, a lender will waive the closing costs without adding them to the principal or raising the rate, but that’s a very rare event, so don’t count on it.