No Closing Cost Refinance

If you’re thinking about refinancing your mortgage, you might be wondering: “Can I refinance with no closing costs?” Or, if you’re buying a home: “Is there a no closing cost mortgage option?” While refinancing your home mortgage can save you money on interest over both the short and long haul, in many cases, it also means paying more closing costs, which can add up to 2% to 6% of the loan amount.

Some lenders offer something called no closing cost refinancing to help cut down on the amount of money homeowners will have to come up with for the refinance. The no closing cost refinancing option allows the borrower to avoid paying closing costs up front in exchange for paying a higher interest rate or having the closing costs baked into the loan principal. But, while these types of loans make it more cost-effective to refinance, they don’t eliminate all extra costs.

How no closing cost refinancing works

A real estate transaction closes when the home’s deed transfers from the seller to the buyer. A deed a written document that shows who owns the property. Depending on the complexity of the transaction, the act of closing on a home involves several parties, including mortgage brokers, attorneys, appraisers and inspectors, who charge extra fees for applications, loan originations and private mortgage insurance, among other things. The term closing costs refers to the total amount of these expenses.

In most cases, these fees are paid when you close on the home. No closing cost refinancing rolls these expenses into the mortgage through a higher interest rate or a higher loan principal. It is worth emphasizing that no closing cost refinancing restructures the closing costs into the loan. This option does not eliminate closing costs.

With the first option, the lender covers the closing costs but charges you a higher interest rate for the life of the loan. As a best practice, be sure to ask the lender or broker for a comparison of the up-front costs, principal, rate and the payments both with and without this rate trade-off to see if it makes financial sense for you.

With the second option, the lender rolls the closing costs into the total loan principal for the no closing cost mortgage. Let’s assume you borrow $100,000 and closing costs are 5% of the loan, or $5,000. In this scenario, the closing costs are tacked on to the loan balance, bringing the total borrowed to $105,000. Be sure to ask the lender or broker if the refinance includes a prepayment penalty, and ask for a thorough explanation of all other fees and penalties before you agree to the new terms.

When you should choose a no closing cost refinance

Obtaining a lower interest rate is generally the motivating factor for refinances. Interest is the top expense you will pay over the course of the mortgage debt, so reducing the cost to carry that debt makes sense to prioritize. If you want to take advantage of lower interest rates but are short on cash, a no closing cost refinance may make sense, depending on the interest rate offer you receive.

Each offer will be different depending on your region, creditworthiness and other factors. Generally speaking, a refinance may be worth it if you can reduce your interest rate by 1% or more.

Let’s say you owe $200,000 on a 30-year loan at a fixed 4% interest rate. That works out to a monthly payment of $955, including interest. If you were to pay this loan for 30 years, the total cost with interest comes to $343,739.

You’ll save $111 per month if you can reduce the monthly interest rate from 4% to 3%, though. That’s a pre-tax savings of $40,180 over the life of the loan. If the total closing costs amount to 2% of the loan, or $4,000, that brings the total net savings to $36,180 over the life of the loan.

What if you rolled the closing costs into the loan principal, though? Let’s assume closing costs are 2%, or $4,000. Instead of borrowing $200,000, you’re borrowing $204,000. Cutting the interest rate by 1% reduces your monthly payment from $955 to $860 per month, a $95 savings worth $34,110 over the life of the loan.

A no cost refinance may make sense if you do not intend to stay in your home for the length of the loan and want to take advantage of the current interest rate environment but may not have the current savings to pull the trigger. If you can obtain a lower interest rate, the savings may justify accepting the higher principal balance.

When you shouldn’t choose a no closing cost refinance

In most cases, you should avoid no closing cost refinancing offers that increase your interest rate. Let’s use the same example from above of $200,000 loan at a 4% fixed interest rate for 30 years with closing costs of 2%. Increasing the interest rate from 4% to 6% raises your monthly payment from $955 to $1,073 per month. The total cost of the loan jumps from $343,739 to $431,676 over the life of the loan.

In other words, it would cost you $231,676 to avoid paying $4,000 in closing costs upfront, assuming the full 2% is tacked onto the current interest rate of 4%.

 PaymentPrincipalInterest
Current: $200k at 4% fixed for 30 years$343,739$200,000$143,739
$4,000 closing costs added to principal, interest rate reduced to 3%$309,626$204,000$105,626
2% added to interest rate$431,676$200,000$231,676

Even if the interest rate increased by 0.25%, though, you’re still paying $154,196 over the life of the loan, which is $10,457 more than the current 4% rate. The only interest rate increase that remotely makes sense would have to be less than 0.10%, which adds less than $4,000 to the total interest paid.

If you’ve been paying your mortgage for some time, it may be tempting to obtain a lower interest rate and not have to pay closing costs to refinance. Remember that refinancing means restarting the clock on your interest payments. In other words, the percentage of your monthly payment that pays interest also resets. With the example used above, you wouldn’t start paying more toward the principal until year 14. But even if you receive a lower interest rate in a refinance, you will still pay more in interest upfront.

Offers will differ from lender to lender. Be sure to review the terms and conditions of any no closing cost refinancing offer. Pay specific attention to language regarding prepayment penalties. Prepayment penalties are fees that lenders can charge if you pay off your mortgage loan early, including for refinancing. Prepayment penalties can add time for you to break-even on the refinancing.

The final word

No closing cost refinancing can make sense for some homeowners if you can find a lower interest rate that justifies it. Homeowners should carefully balance the implications of spreading costs out across their mortgage schedule to avoid paying closing costs. The higher principal increases the total cost of the loan but can make sense if accompanied by a lower interest rate. Homeowners should be wary of no closing cost refinancing offers that increase the interest rate, particularly given the current interest rate environment.

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Alexander Clark

Personal Finance Contributing Writer