Refinancing your mortgage can seem like a great idea until you hear about the closing costs. Do you really want to bring thousands of dollars to the table yet again? If you refinance soon after you closed on your purchase, that extra money can really hurt you financially.
You’ve heard of the option to get away without bringing any money to the table, but how does it work? Are you really getting out of paying closing costs?
The No Closing Cost Refinance
It’s true, you can get a loan and pay no closing costs upfront. That’s the key word though. You are still paying them, just in a different way. When lenders charge you at the closing for the costs to process, underwrite, and close your loan, they collect the money right then and there. It’s like prepaid interest to them. Rather than you paying the costs throughout the life of the loan in the interest charges, you pay them now.
If you choose to not pay any costs at the closing, the lender will give you a higher interest rate. Just how much higher depends on the lender. You can typically expect the rate to be at least 0.5% higher, though. This is how the lender makes up the difference. Rather than receiving the money upfront, they receive it over the life of the loan.
A lender will present this option to you by quoting you an interest rate with closing costs and an interest rate with no costs to close the loan. You can then weigh the pros and cons of each option.
Wrapping the Closing Costs Into the Loan
The other option, if you don’t qualify for a no closing cost loan or you don’t want the higher rate is to wrap the costs into the loan. This requires you to have sufficient equity in the home in order to stay within the LTV guidelines, though.
If you decide to wrap the costs into the loan, you’ll increase your principal balance. Let’s say closing costs are $5,000. You would add $5,000 to your loan balance. Lenders consider this a ‘limited cash-out refinance’, which requires better than average credit and low debt ratios.
While this is an option, you should give it careful consideration before jumping on board. When you wrap the costs into the loan, you increase not only your principal balance, but also your monthly payment. Plus, if you plan to keep the loan and the home for the long-term, it could end up costing you much more, especially if you took out a 30-year term. Financing $5,000 over 30 years will cost you a lot more than if you paid it at the closing table because you pay interest on the amount for that entire time.
Qualifying for a No Closing Cost Loan
Qualifying for a no closing cost loan usually requires that you have better than average credit, debt ratios in line with the program and no ‘ negative qualifying factors.’ In other words, lenders usually only provide this option to borrowers that are a good risk. You want to show the lender that you are not a high risk for default.
Remember, lenders use the money collected at closing as ‘prepaid interest.’ Without that money upfront, they take a big risk. If you default on the loan, they did not have the benefit of getting paid any money at the closing. The more qualifications you can provide the lender with, the better your chances of approval for this type of loan.
Before you accept a no closing cost loan from a lender because it sounds like a great deal, consider the full effect of the loan. How long do you plan to stay in the home? How much will you save by refinancing and not paying the costs upfront? If you plan to stay in the home for the long-term, paying the costs may be the better option as you’ll receive a lower interest that you can carry for the life of the loan. If you think you may move in the next five to ten years, though, saving that money upfront can be the better financial option.