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In the world of lending, a no-closing-cost mortgage doesn’t mean there’s no closing costs.  In fact, closing costs usually total thousands of dollars and the economics of mortgages doesn’t allow for them to simply vanish.

So here’s what really happens with closing costs. You either write a check to pay those fees at the closing table, add them to the loan amount or accept a higher interest rate in return for the lender assuming those costs. The result of the last two options is called a no-closing-cost mortgage or no-closing-cost refinance.

“There’s two ways people achieve no-closing-cost mortgages,” says Bob Walters, president and chief operating officer at mortgage lender Quicken Loans. “The mortgage company will flat-out waive them, which doesn’t happen that often. Or, they will present the rate (with) closing costs, and if you don’t want to pay, you’ll take a slightly higher rate.”

The same could apply to no-closing-cost refinance rates.

For example, you may be offered a mortgage at a rate of 3.75 percent and pay closing costs. Or, you can take a no-closing-cost mortgage at a higher 4.125 percent rate.

What are mortgage closing costs?

Closing costs include services such as the loan origination, appraisal and title search fees and title insurance premiums. These costs vary from state to state, but on average the costs have been rising.

Here’s a list of common fees included in closing costs:

  • Loan costs
    • Origination fee
    • Application fee
    • Underwriting fee
    • Discount points, if any (upfront payments that reduce the interest rate)
    • Settlement fee
    • Title fee
    • Appraisal fee
    • Credit report
  • Other costs
    • Property taxes
    • Homeowners insurance premium
    • Prepaid portions of your mortgage payment, such as interest
    • Flood insurance, if required

How much are average closing costs?

Closing costs typically amount to 2 percent or more of a home’s purchase price.

According to Bankrate’s Closing Costs Survey, the origination and third-party fees on a $200,000 mortgage cost an average of $2,084.

Factoring in taxes, title fees, settlement fees and so on, the national average closing costs for a single-family property add up to $5,651, according to a recent survey from ClosingCorp, a real estate closing cost data provider.

Extra costs of a zero-closing-cost mortgage?

A no-closing-cost loan doesn’t mean you get something for nothing. Rather, it means you’re agreeing to include the closing costs in your financing in one of these ways:

  • Closing costs added to the mortgage
    • Your lender may let you add closing costs to your loan. Your loan will be larger, which means you’ll pay a slightly higher amount each month. You’ll pay interest on the additional amount, a substantial amount over the life of the loan.
  • The interest rate is increased to cover the closing costs
    • The bank may offer a “lender credit” to cover closing costs. It then charges you a higher interest rate to make up the difference.

Can the seller pay my closing costs?

Some buyers negotiate for the seller to pay some or all closing costs. Again, that doesn’t mean you’re off the hook financially. The seller may offer closing costs as a bargaining chip, in exchange for a concession on your part.

Here are some typical cases:

  • Seller pays closing costs in lieu of lowering the purchase price
    • The seller might agree to pay closing costs but require you to pay a higher price. This allows you to save money upfront, but remember you’re going to finance a higher amount — and pay interest on it too.
  • Seller pays closing cost in lieu of making repairs
    • Suppose the home inspection reveals that $4,000 of plumbing repairs are needed. Rather than doing the repairs, the seller might offer to pay that amount toward your closing costs. This would help complete the sale more quickly and could work in your favor if you plan to do renovations anyway. You would conserve cash upfront but have to spend more later.

Advantages of a no-closing-cost mortgage

A no-closing-cost mortgage might be suitable for homebuyers who:

  • Can’t afford the closing costs upfront
  • Plan to be in the house for less than five years
  • Need cash reserves for renovations

No-closing-cost mortgages are attractive to borrowers who don’t have the cash to pay fees upfront. Waiving the closing costs may be the ticket to getting a mortgage for a new home or a refinance.

If you don’t plan to stay in your home more than five years, a no-closing-cost mortgage also makes sense. With a traditional mortgage, it could take more than five years to recoup the closing costs.

The slightly higher mortgage rate associated with a no-closing-cost mortgage is still likely to be less-expensive over five years than what you would pay upfront in closing costs.

“You have to look at the break-even,” says Cameron Findlay, executive vice president of capital markets at Paramount Equity Mortgage.

“Say, for example, you had a loan for a while at 6.5 percent and are only looking at being in the house for another four years. Then, you are probably a good candidate. You don’t want to put money down if you are going to be there for four years.”

Paying a slightly higher interest rate to forgo closing costs may also make sense if you need the cash to do renovations on your home.

Drawbacks of a no-closing-cost mortgage

With a no-closing-cost mortgage, you’re basically delaying and spreading out the closing costs. This type of loan might not work well for homebuyers who:

  • Expect to stay in the house for the long term
  • Want a monthly payment that is as low as possible
  • Want to minimize the overall amount of interest paid

Do you plan to stay in your home more than five years? If so, a no-closing-cost loan likely will end up costing you more than a loan with closing costs. That’s true whether you’re taking out a mortgage for a new purchase or refinancing an existing loan.

Typically, you’ll break even on your closing costs in a few years. Going with a no-closing-cost loan saddles you with a higher interest rate over the rest of the home loan. That could end up costing you a lot more than the upfront fees if you keep the mortgage for a long time.

Take the hypothetical example of two choices for a $150,000 loan. One has a rate of 3.75 percent with $3,500 in closing costs; the other has a rate of 4.25 percent, with no closing costs.

Going with the higher-rate, no-closing-cost option runs $43.24 a month more, or $15,567 more over 30 years. In this scenario, it takes six years and nine months to break even and recoup the closing costs via the lower monthly house payments.

“It’s not something that every lender will offer, but it doesn’t hurt to ask about that option,” says Frank Nothaft, the chief economist at CoreLogic, a firm that analyzes real estate and other financial data. “It’s up to consumers to decide if the trade-off makes sense.”

Should you do a no-cost refinancing?

Refinancing means you to pay off your original mortgage and take out a new one with different terms. You could benefit if interest rates have fallen since you got your mortgage or if your credit score has improved significantly. In any case, you need to figure out whether the savings will be worthwhile.

Banks can mean different things by “no-cost” refinancing. Typically, you’ll end up borrowing a larger amount or paying a higher rate, just as with no-closing-cost mortgages. Be sure you understand the specific terms.

The Federal Reserve offers these tips to homeowners considering refinancing:

  • Ask the lender to provide a comparison of the refinancing with and without closing costs, so you can clearly understand the upfront costs, principal, interest rates and monthly payments in each case.
  • Ask whether there is a prepayment penalty.
  • Ask to have all the fees and penalties spelled out.
  • Consider how many years you expect to keep your home. How much will you benefit from refinancing during that period of time. What if you sell your house sooner? Or later?

When considering a no-closing-cost mortgage or refinancing, think about all the tradeoffs involved. Instead of taking a higher interest rate or larger loan amount, you just might decide it’s worth stretching to pay the closing costs upfront