Calculating the costs of "no closing cost" mortgages

When you've already saved up a considerable amount of money to make a down payment on a home, it can be dismaying to see closing costs take a considerable bite out of your bank account. These expenses, for services such as a title insurance and early interest charges, can easily add thousands of dollars to the initial sum required to purchase a property.

So it can be particularly enticing to see a loan advertised as having no closing costs. Who wouldn't want to take out a mortgage that keeps some of your hard-earned money in your pocket?

Buyers should be careful to make sure they understand the conditions of these types of loans, however. No closing cost loans rarely waive these expenses; instead, they'll distribute them in a different way. While this can be beneficial in some circumstances, other buyers may find themselves saving money up front but paying vastly more over the life of the loan.

This type of mortgage, available for both purchase and refinance mortgages, typically charges a higher interest rate than a loan with closing costs. David Reed, writing for Realty Times, says borrowers can opt to include points on the mortgage to increase the interest rate in exchange for a lender credit. This credit can then be applied to the closing costs. Hal M. Bundrick, writing for the financial site NerdWallet, says this closing costs may also simply be added to the principal balance of the loan.

In both scenarios, you'll save money at the outset but end up paying more over time. With a higher interest rate, your monthly payment will be greater than if you paid closing costs. An increased principal will have a less pronounced effect on your monthly payments, but you'll still pay more as you repay the closing costs, plus interest, over the life of the loan.

Taking on the higher monthly payments in a no closing costs mortgage can be helpful if you plan to sell or refinance the home within a few years, or if you're refinancing and only have a few years left to pay off the loan. Justin Pritchard, writing for the financial site The Balance, says this may allow you to save more money by avoiding closing costs than you what you would pay out with higher monthly payments.

Some simple math will let you know when this "break even" point will occur. Kimberly Lankford, writing for Kiplinger, says you can ask a lender for an estimate on what the closing costs will be and how much a no closing cost mortgage will add to your monthly payments. Dividing the closing costs by the added monthly expense will let you know how many months it will take before the lender recoups this money. If you are planning to leave the home before this point, a no closing cost mortgage can be useful.

You might also opt for a higher rate if you expect rates will fall in the near future, since you'll be able to refinance at a lower rate before the break even point. Pritchard says there are certain risks to this approach, since rates may be higher than expected at the time you expect to refinance.

A no closing cost mortgage can also be advantageous if closing costs will strain your bank account. Donna Fuscaldo, writing for the financial site Bankrate, says being able to keep money on hand will help if you know you'll need to complete renovations on your newly purchased home.

No closing costs mortgages are much less effective if you plan to be in a home for a long time. Since you'll be paying a higher interest rate over the course of the loan, you might end up paying tens of thousands of dollars in interest to the lender by the time you pay off the mortgage – considerably more than the few thousand dollars you'll save at closing.

This type of loan also makes less sense if interest rates are already low and you expect them to increase. Pritchard says a conventional mortgage is preferable if you can afford to get one with the lowest possible rate.

Some lenders will have conditions that will reduce the benefits of a no closing cost mortgage. Pamela Boykoff, writing for Lending Tree, says lenders may include prepayment penalties or even require a borrower to repay closing costs if you seek to discharge the loan before a certain date.

By shopping around and comparing different lenders, you'll be able to evaluate different offers and see if other money-saving options are available. Lenders may be willing to negotiate some closing costs, reducing or eliminating expenses such as origination fees. Lankford says lenders are more likely to be flexible if you have a good credit score or if you're taking out a large loan.

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