Just as there is no such thing as a free lunch, there’s really no such thing as refinancing a mortgage for free, no matter how appealing a no-closing-costs refi may sound or look on paper.
Sure, with a little (or more likely a lot) of signing on dotted lines, you may find yourself paying less each month for your mortgage, without having to hand over a dollar in fees to anyone. But rest assured, the devil is in the detail, or more likely, buried amid a plethora of loan-origination papers.
There is a cost to your new, lower monthly mortgage payment, and it’s most likely to be found in a principal balance on your loan that suddenly goes up rather than down, or an interest rate that’s a bit higher than the one you might have nabbed had you written a check for a few thousand dollars up front.
Semantics aside, the fabled no-closing-cost refi does have its perks, and may ultimately be the way to go if the circumstances are right. Here’s how to decide whether it makes sense for you.
What is No Closing Cost Refinancing
In a nutshell, no closing cost refinancing is when the borrower gets a new, lower-interest rate home loan without having to pay anything up front.
As much as we’d like to pretend otherwise, the expenses of refinancing a loan just don’t disappear out of the goodness of your local bank or mortgage agent’s heart.
Instead of requiring the borrower to write a check for the various expenses associated with retiring your current loan and securing a new one, the lender will typically do one of two things:
1. Add the closing costs to the principal, or unpaid balance, of your loan (that $150,000 mortgage instantly grows to around $153,000, or maybe more).
2. Waive the costs in exchange for giving you a higher interest rate, meaning that you’ll pay a little bit more each month — which can add up to a whole lot over the 30-year term of a standard mortgage.
What Are Closing Costs
Closing costs typically refer to a wide range of administrative and processing fees that come with purchasing a home or refinancing a mortgage.
Closing costs can consist of:
- Government recording costs: These are fees assessed for legally recording your deed, mortgage and documents related to the loan. Either a buyer or seller must pay these fees.
- Application fee: Charged for the work done to process your loan application.
- Appraisal fees: Costs to have a professional put a value on your home.
- Credit report fees: The cost for a lender to see your credit report.
- Inspection fee: Paying a professional to confirm you house is structurally sound and ready to be lived in.
- Lender origination fees: Upfront cost – usually 0.5 to 1% of the loan — for processing a loan.
- Title services: Title insurance protects you if someone sues you because they say they have a claim on the home.
- Tax service fees: This is a fee collected by the lender to make sure that property taxes are paid on time.
- Survey fees: If the lender requires a survey of the property before finalizing a loan.
- Attorney fees: Costs for an attorney to handle the closing transaction.
Other fees that may be included in closing a mortgage are a VA Funding Fee (if refinancing a VA loan), prepaid interest if your lender asks you to pay the first month’s interest of your new loan up front, and optional discount “points” that enable you to pay an up-front fee for a lower interest rate (one point is equal to 1% of the loan amount).
What Is the Average Closing Cost to Refinance a Mortgage
By now, you’re probably thinking, “Let’s cut to the chase. How much do all these costs add up to?” Borrowers can expect to “pay” anywhere between 2% and 6% of their outstanding principal in closing costs, which depending on the size of your loan and/or the state in which you live, generally ranges from $2,500 to $4,500.
Be forewarned, however, that closing costs can vary considerably by location. Other factors such as your credit score, loan type and equity in your home can also affect the total bill when all is said and done. To get a better sense of what you can expect to be charged in closing costs, try out the online refinancing calculator at Freddie Mac.
Pros and Cons of Avoiding Closing Costs When Refinancing
Deciding whether to avoid paying closing costs up front when refinancing a mortgage can pose a head-scratching dilemma. There are many factors to consider, including the sting to your savings or budget of paying several thousand dollars out of pocket.
Here are the pros and cons you should weigh:
Pros of No Closing Cost Refinance
- The most obvious one is avoiding upfront fees, meaning you don’t have to pull out your checkbook or drain your savings account before getting your new loan. That’s money you can apply to other expenses, save for an emergency, or invest.
- Folding closing costs into the loan balance can save you thousands of dollars up front while only minimally increasing your monthly mortgage payment. For example, adding $3,500 in closing costs to a $200,000, 30-year fixed rate mortgage would leave you with a $914 monthly payment, only $16 more than you would pay if you paid the closing costs up front. That is only an additional $192 per year. Of course, you’re still on the hook for the closing costs one way or another, but folding them into your principal gives you the option of taking your sweet time to pay it off.
- Taking the closing costs out of the equation also makes it easier for borrowers to compare interest rates that will provide the most savings, particularly if the lender is going to waive the closing costs in exchange for a higher interest rate.
Cons of No Closing Cost Refinance
- You’ll end up with higher monthly payments, either by having the closing costs tacked onto your loan balance or getting a higher interest rate in exchange for the lender waiving the closing costs.
- If you don’t plan to sell your home, you can easily wind up paying much more over the life of the loan than you saved in closing costs.
- Your loan may come with a prepayment penalty to ensure that the lender is able to recover the costs of the loan in case you decide to refinance again.
When to Refinance Without Closing Costs and When Not to
Ultimately, the decision of whether to refinance without closing costs largely comes down to peering into your own crystal ball. If you see yourself selling your house, or refinancing again, within three to five years, it’s probably better to skip on paying closing costs. Otherwise, you may end up paying more in refi costs than you are able to save from your lower monthly payments.
Conversely, if you’re planning to stay in your home for the long haul and are reasonably confident you won’t look to refinance again, paying closing costs up front is the way to go, assuming you have the cash available. As the years pass, your lower monthly payments will more than offset the financial sting from paying closing costs at the beginning of the mortgage. Over the length of the loan you should end up far ahead.
For example, if you were to pay $3,500 in closing costs up front for a $200,000, 30-year fixed rate loan at 3.5% interest, your monthly mortgage payment would be $898. If instead you took a mortgage that waived closing costs in exchange for a higher 4% interest rate, your monthly loan payment would grow to $955.
Over the life of the loan, you would pay an additional $20,520 because of the higher interest rate. But if you sold the home and paid off the loan in only three years, the higher interest rate would only cost you an additional $2,052 — far less than the $3,500 you saved in closing costs.
If it all seems confusing, here are a few rules of thumb for when it might make sense to take a no-closing-cost refi:
- You don’t have sufficient savings to pay for closing costs, or they would deplete your emergency savings.
- You are looking for money to fund home repairs or improvements, in which case cashing out some of your equity in the form of a larger mortgage at a lower interest rate might be more cost-effective than securing a home equity loan.
- You think there is a good chance you will be selling your home and/or paying off the loan within five years.
Whichever way you are leaning, here are some tips for making sure you have all the information you need to make the best possible decision:
Ask your lender or broker for detailed loan estimates of the up-front fees, principal, interest rate and payments with and without paying closing costs. A loan estimate is a three-page form that explains important details about the loan you are seeking. It must be provided to you by your lender within three days after applying for your loan.
Ask the lender offering a no-closing-cost loan to explain all the fees and penalties, including whether the loan comes with a prepayment penalty, before agreeing to the terms.
Use a step-by-step worksheet to give yourself an estimate of the time it will take to recover your financing costs before you begin to benefit from a lower mortgage rate (the “break-even” point). Depending on your plans for the home and paying off the loan, this will give you a better idea of whether you will come out ahead by paying the costs up front or foregoing the closing costs for a higher interest rate or larger loan balance.
Choosing whether to take a no-closing-costs loan is one of the most important decisions you will make in the process of refinancing your mortgage. Depending on the circumstances, it can spare you the unneeded financial pain of dipping into your savings to the tune of thousands of dollars, or it could result in having to pay thousands of dollars in additional interest costs over the life of the loan.