How No Closing Cost Loans Work

The Truth About No Closing Cost Loans

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Nothing is free. Sometimes you have to look closely. Jack Halford / EyeEm / Getty Images

Buying property is expensive – and you know you’ll need to spend a little more on improvements after the deal is done – so it makes sense that buyers want to keep cash available. No closing cost loans can help you reduce the amount it takes to buy a home, but they’re certainly not free loans.

If you’re tempted to use a loan with no closing costs, you need to understand how they work, what the tradeoffs are, and when they make the most sense.

No Free Lunch

Any time you borrow money, somebody gets paid. The lender earns interest which is easy enough to understand, but what about transaction costs? One-time charges for credit checks, appraisals, origination fees, and title searches need to be paid. Mortgage brokers earn a commission, and others might earn referral fees. Who pays when the costs are not clearly shown?

No Closing Costs = "Higher Rate"

When you use a no closing cost loan, you still pay the fees. You’ll notice that these loans have higher interest rates. Instead of paying up front in a lump sum (by writing a check, for example), you pay a little bit extra over time. The cost gets added – in tiny chunks – to each monthly payment you make.

That’s not necessarily a good or bad thing. The question is how much extra you’ll pay month after month – and is that a better deal than paying all of the costs right now?

To figure that out, you might need to do a little math, and you’ll need to make some assumptions about how long you’ll keep the loan (before you sell the home or refinance the loan into a different loan).

A loan with a higher interest rate means you’ll have a higher monthly payment. If you’re curious about how that works, see how to calculate monthly payments – the interest rate is a key “ingredient” in that calculation. Compare the rates available for loans with and without closing costs.

For example, the difference might be 0.5% (get actual quotes from lenders based on your loan and credit score to be sure you’re working with relevant numbers).

On a $250,000 loan, the monthly principal and interest payment would be $1342.05 if you borrow at 5%. If you bump that up to 5.5% (because you’ll pay no closing costs), the payment would change to $1419.47. For how many months is it worth paying that extra $77.42 per month? It will depend on how much the closing costs are, and how badly you want to keep the cash in your pocket.

When No Closing Costs is a Good Idea

Paying extra each month is not necessarily bad. It can be the right choice in some cases. Of course, you should base your decision on the big picture – not the imminent pain of writing large checks for closing costs today. Loans with no closing costs work out best when:

  • Rates are high and you expect them to go lower soon
  • You’ll only keep the loan for a few years

If rates will go down in the near future, it might not make sense to pay large expenses out of pocket to lock in a high-rate loan. You might try to just pay a little extra each month, and then refinance the loan if rates fall. Unfortunately, you can never be certain about the size, direction, or timing of interest rate changes, so you have to make some assumptions and take some risks (whether you pay the costs out of pocket or not).

If you’re fairly certain that you’ll sell the house or refinance the loan within a few years (five years or less, let’s say), then it might make sense to skip paying the closing costs for now. You’ll pay that higher monthly payment for just a few years – not the entire term of a 30-year mortgage. You might know that a job change is in your future, or issues in your credit report will allow you to get a much better loan in the future. Again, it’s impossible to predict the future, but you can always make plans and head in that direction.

When it's a Bad Idea

It hurts to pay large costs right now, but that might be the right thing to do if you can set yourself up nicely for the long term. Securing a smaller monthly payment for many years to come can help you weather some of life’s surprises (and spend less overall, if you end up keeping the loan for a long time).

Think twice about taking the higher rate (with no closing costs) when:

  • Rates are relatively low, and you expect them to rise
  • You’ll keep the loan for many years
  • You can afford to buy the cheapest rate possible

How to Get the Best Loan

If you’re interested in no closing cost loans, be sure to consider all the factors and spend at least a little time running the numbers. Yes, it feels like homework, but it’s an important decision. Then, shop around.

You can often get a variety of quotes from the same broker – some of them with closing costs and others with different levels of closing costs. With all of the options in front of you, you’ll see that you can find a level of cost that’s acceptable to you.

Do some comparison shopping as well. Ask several mortgage brokers as well as your bank or credit union for quotes. Check with an online lender. You’ll find that they structure closing costs differently and can offer different rates.

Closing costs are complex, and no closing cost loans are not always as cheap as they seem. Make sure you understand how closing costs work before pulling the trigger.