If your homebuying budget includes only an estimated purchase price and a down payment, then you might want to rethink your budget: It also needs to account for closing costs.
Closing costs are the various fees you pay to finalize the purchase of a home. Buyers typically pay between 2% and 5% of their home’s purchase price in closing costs, according to Zillow, an online real estate marketplace.
Many lenders, however, offer no-closing-cost mortgages to make buying more attainable by minimizing the initial out-of-pocket costs. A no-closing-cost mortgage, also called a zero-closing-cost mortgage, is convenient for buyers who want to hold on to their cash reserves. But make no mistake, you’ll pay for the costs eventually. Be sure you understand the differences between this type of loan and others before you choose one.
What Is a No Closing Cost Mortgage?
Many charges can fall under the closing cost umbrella. Typically, closing costs include items such as the:
— Appraisal fee
— Courier fee
— Administrative fee
— Processing fee
— Credit check fee
— Transfer taxes
— Flood certification
— Discount points
— Title search fee
— Title insurance
A no-closing-cost mortgage works by charging the borrower a higher interest rate, allowing the lender to apply the premium toward closing costs, says Matthew Hackett, mortgage operations manager at mortgage lender Equity Now.
“It’s not a free lunch; it’s a trade-off between paying more fees at closing or paying more interest over the life of the loan,” Hackett says.
Alternately, a buyer can obtain a no-closing-cost mortgage if the lender agrees to waive closing costs. But that’s a rarity because lenders benefit by accounting for your closing costs in the loan rate.
Amy Tierce, senior loan officer at mortgage lender Radius Financial Group, says, “At higher rates, lenders earn ‘overage,’ or an amount above their income targets.” This overage is how they make up for paying some or all of a buyer’s closing costs.
Tierce says no-closing-cost mortgages also can be used when you’re refinancing. “With a refinance, a borrower can roll the closing costs into the loan amount or be charged a higher rate,” she says, whereas, “with a purchase, closing costs can be built into the rate but not rolled into the loan.”
Either way, know how you might come out ahead with a no-closing-cost mortgage — and what it could cost you over time.
Pros and Cons of No Closing Costs Loans
The chief advantage of using a no-closing-cost loan to buy or refinance a home is the upfront savings.
“Having a no-closing-cost loan can help a borrower who is short of funds to close,” Tierce says.
[Read: Best Mortgage Lenders.]
That’s a plus if you’ve made a large down payment and paid out of pocket for your appraisal and inspection. You may also want to preserve cash to make renovations or upgrades once you move into the home.
Assigning a dollar value to the savings of a no-closing-cost mortgage depends largely on your home’s purchase price and your closing costs. With a $250,000 mortgage, for instance, closing costs may range from $5,000 to $12,500, following the 2% to 5% guideline. If paying those costs out of pocket would deplete your cash, then a no-closing-cost loan could seem like the obvious choice.
But weigh the initial savings against what you might pay in interest over the life of the loan at a higher rate. Even a fraction of a point difference in your rate could potentially cost you thousands of dollars over the long term.
Assume that Buyer A gets a $250,000 mortgage, pays closing costs out of pocket and locks in a 4% rate. Buyer B, on the other hand, finances the same amount with no closing costs at a rate of 4.25%.
Over a 30-year mortgage term, Buyer A would pay $179,674 in interest for the mortgage. Buyer B, meanwhile, would pay $192,746, a difference of $13,072. Compare about $13,000 in additional interest to the $5,000 to $12,500 Buyer B could have paid in closing costs.
Doing the math on closing costs and what you might pay for a higher rate is important for two reasons. One, financing closing costs could affect your ability to qualify for a loan. And, two, a higher interest rate can translate to a higher monthly payment, which could push the limits of your homebuying budget.
“If the borrower’s qualifications are tight, then the higher interest rate could be a problem,” Tierce says.
Using the previous example, the estimated monthly payment for Buyer A would be $1,194. Buyer B’s payment would come to $1,230. Not a huge difference, but you — and your lender — have to consider the bigger picture in terms of your debt-to-income ratio.
Debt-to-income ratio represents the percentage of your income that goes toward paying off debt each month. Ideally, mortgage lenders prefer a DTI of 43% or less. That figure includes what you spend on your mortgage as well as credit cards, student loans and other debts. If accepting a higher rate to avoid closing costs increases your estimated monthly payment, you could tip your DTI too far over the mark for a lender to approve your loan.
Even if a no-closing-cost mortgage is feasible, and you’re comfortable with paying more in interest, that doesn’t necessarily mean you won’t need to have some skin in the game. Hackett says, “No closing costs doesn’t mean no money due at the table.”
For instance, your lender may allow you to get a no-closing-cost loan that covers customary, one-time closing fees, such as escrow or tax recording. But you may still have to pay for other fees typically charged at closing, including real estate taxes, prepaid interest, transfer fees and private mortgage insurance.
Are There Other Ways to Avoid Closing Costs?
A no-closing-cost mortgage isn’t the only option for reducing what you spend to close. You can take other actions to help manage the costs.
The first is asking your mortgage lender to waive some or all of your closing fees. But this may be a long shot if the lender doesn’t receive an incentive, such as the ability to charge you a higher interest rate.
A more realistic solution may be to ask the seller to cover some of the closing costs for you using a concession. A seller concession works like this:
— You determine the closing costs you want the seller to pay.
— If the seller agrees, that amount is added to the purchase price.
— You get a mortgage for the new purchase price.
— At closing, the original purchase price is paid to the seller, while the difference goes to paying closing costs.
This is a legal way to roll the expenses of closing into your loan, which ordinarily isn’t allowed unless you’re refinancing a mortgage.
However, keep in mind that if you’re rolling the costs into the loan, you’ll pay interest on them. And by increasing the total loan amount, you will increase the monthly payment and may complicate your DTI, as with a no-closing-cost loan.
[Read: Best Mortgage Refinance Lenders.]
And even with a seller concession, you may still be bringing money to closing. The amount of seller concessions you are allowed depends on the loan type. Here’s how the maximums compare:
— Federal Housing Administration loans: 6%
— U.S. Department of Agriculture loans: 6%
— U.S. Department of Veterans Affairs loans: 4%
— Conforming loans (Fannie Mae and Freddie Mac): 3% to 9%
Tierce says if you want to ask the seller to pick up the tab for some of your closing costs, get your agent on board. Agents can help negotiate seller concessions once your offer has been accepted.
Ask These Questions Before Getting a No Closing Cost Mortgage
If you’re considering a no-closing-cost loan, think through the decision carefully. Weigh the pros and cons, and keep these questions in mind:
— What’s my motivation for getting a no-closing-cost home loan?
— How much could I save by not paying closing costs upfront?
— What would my new loan rate be, and how does it affect the monthly payment?
— Would a higher monthly payment make qualifying for a loan more difficult?
— How would a no-closing-cost option affect total interest paid?
— How long do I plan to stay in the home?
“It really is a matter of the holding period and whether the higher interest rate required to offset the closing costs will ultimately end up costing the borrower more in the long run,” Hackett says.
That assumes you’re staying in the home for the full mortgage term. If you were to move within a few years of buying, the financial impact of paying a higher interest rate might be more muted. Examine all the angles if you’re considering a no-closing-cost loan.
Tierce says, “A buyer should ask their lender to compare options with and without closing costs to determine what makes most sense for their situation.”
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