Refinancing costs money. Any time you take out a new mortgage, the lender incurs costs. They pass those costs onto you. How you pay them is up to you. There are a few choices including paying them in cash at the closing; rolling them into your loan; and letting the lender pay them. The last two options make up the no closing cost refinance options. Either way, you do not physically pay the closing costs at the closing In essence, though, no matter what you choose, you still pay them. Here we will discuss how this type of refinance works and weigh the pros and cons for you.
How a No Closing Cost Refinance Works
You know that every loan has costs. Lenders have to pull your credit, evaluate your documents, and go over your property. Basically, they determine if you are worthy of another mortgage. So how can they provide you with a no closing cost refinance? They make it up in other ways. Here is a look at both options:
- Wrapping the costs into the loan – You can wrap your closing costs into your loan. This means you pay for the costs over time. If you take out a 30-year loan, you pay the closing costs over a 30-year period. When you add interest to that amount, the $5,000 in closing costs suddenly become a much larger amount.
- Letting the lender pay the costs – Some lenders offer the opportunity to pay the closing costs for you. Again, you pay them, just in a different way. With this method, you pay a higher interest rate. Just how much higher depends on the lender. What you do not pay in this instance is closing costs. Instead, the lender uses the higher interest payments that you make to cover the closing costs.
As you can see, it all evens out. One way or another you pay closing costs. Now let’s look at the pros and cons of this type of loan.
Pros of a No Closing Cost Loan
There are several benefits of the no closing cost loan. They include:
- Less cash at the closing – Coming up with the necessary cash to close a loan is difficult. Closing costs can total up to 5% of the loan amount. On a $200,000 loan, this means $10,000. That is not small change! With the no closing cost option, you will not have to come up with this money. This can make it possible for you to refinance when you would otherwise be unable to if you needed to bring cash.
- A cheaper option for the short-term – If you know you will move away from the home within 5 years, you can save a lot of money. The no-closing cost option does cost more in interest, but if you move in less than 5 years, you will likely pay less in interest than you would in closing costs. This saves you in the long run.
- Makes refinancing in the future affordable – If you know you will refinance again in the near future, you benefit by not paying closing costs now. Let’s say you opt for an ARM loan right now so you can have lower payments for a while. You can enjoy more affordable payments during the initial term and refinance again before the loan adjusts. Without paying closing costs on this loan, you save money.
Cons of a No Closing Cost Loan
Just as any other loan type, there are disadvantages of using a no closing cost loan:
- Higher interest rate – The tradeoff for no closing costs is a higher interest rate. If you refinance because you want a lower rate, the no closing cost option might not work. Remember, lenders are in the business to make money. They will make back the difference in the closing costs one way or another.
- Higher payment – Along with the higher interest rate, you pay a higher mortgage payment. Be very careful when you opt for this choice. Make sure you can comfortably afford the higher payment in exchange for no closing costs.
- Pay more interest over the life of the loan – If you live in the home for more than 5 years on average, you will pay more interest over the life of the loan. Typically, the break-even point for average closing costs is 5 years. This means after those 5 years you start reaping the savings of a lower interest rate. If you took the higher interest rate and no closing costs, though, you miss the savings of the loan. After 5 years, you will still pay the higher interest rate. The closing costs would have been paid off by this point and now you are stuck with the higher payment. Adding up the interest over the life of the loan can make you realize the depth of this decision.
How do you decide if you should use a no-closing cost refinance loan? Look at your plans. Is this a home you will stay in for many years? If so, you may benefit from a lower interest rate and paying the closing costs up front. If you know you will move in a few years, go ahead, take the higher interest rate, and avoid the closing costs. As long as you move before that break-even point, you come out ahead in the situation.
If you are unsure about what is right for you, consult with several mortgage lenders. Compare their offers to your situation and see what works. Just because no closing costs sounds appealing, it is not always the right decision for every household. Make sure it is the right one for you before you take it.