When Does a No-Cost Mortgage or Refinance Make Sense?

Whether you’re buying a new home or refinancing your existing home loan, getting a mortgage is an expensive process.

It involves paying closing costs, which can be upwards of thousands of dollars, depending on your mortgage balance. 

These fees are a big hurdle to buying a home and refinancing, but lack of available cash doesn’t mean you can’t get a mortgage.

Naturally, you want to reduce your out-of-pocket expense. So if a bank or mortgage broker offers a no-cost mortgage or refinance, you might jump at this opportunity. 

Before you get too excited, though, make sure you understand how a no-cost mortgage works.

What is a No-Cost Mortgage or Refinance?

A no-cost mortgage or refinance involves getting a home loan without paying closing costs out-of-pocket.

Therefore, you don’t come to closing with a cashier’s check or wired funds to cover your lender and third-party fees.

These fees include:

• loan origination
• home appraisal fee
• attorney fees
• title search
• application 
• discount points
• prepaids (property taxes, insurance, etc.)

If you’re purchasing a new property, be mindful that your mortgage program might require a down payment. If so, you’re still responsible for this expense. A no-cost mortgage only removes the burden of lender and third-party fees.

But even though you don’t bring cash to closing, a no-cost mortgage isn’t as free as you might think.

The reality is:

There’s no such thing as a true no-cost mortgage.

The process of getting a home loan involves expenses that must be paid by someone. 

On average, closing costs range from 2 percent to 5 percent of the loan balance. Your lender might give the impression that they’re covering the cost for you, but they’re actually not.

Pros vs. Cons

Before getting a no-cost mortgage or refinance, here’s a look at the good and the bad aspects of these loans. 

Benefits

The benefit of a no-cost mortgage is obvious: Get a home loan without spending too much of your own money. 

As a first-time buyer, out-of-pocket costs are one of the biggest obstacles to homeownership. Not only do you pay closing costs, you also have to worry about a down payment. 

Down payments range from 3.5 percent to 5 percent, depending on the mortgage program. Saving up for this expense “and” closing costs can make it impossible for some would-be first-timers to purchase a property.

A no-cost mortgage, however, helps relieve some of this burden. When you don’t have to worry about closing costs, you can focus all your efforts on saving for the down payment and get the keys to a new home sooner.

This also applies when refinancing a mortgage. When interest rates drop, refinancing is a great opportunity to get a lower rate. This reduces how much interest you pay over the life of the loan, and it can lower your monthly payment. 

But if you don’t have cash for closing, you might feel that you’re unable to take advantage of the savings. A no-cost refinance, however, can put a new loan within your reach.

Drawbacks

But again, no-cost mortgages aren’t exactly free. The main drawback is that these mortgages often result in a higher mortgage balance or a slightly higher mortgage rate.

When a mortgage lender says a borrower won’t pay anything out-of-pocket for their closing costs, what the lender actually does is wrap the closing costs into their mortgage balance. 

To illustrate, if your mortgage is for $210,000, and you owe $5,000 in closing costs, the lender may increase your mortgage balance to $215,000 to compensate for “no-cost.” 

You’re still paying the closing costs, you’re just not paying this cost upfront. 

Or, the lender may take another approach. The bank might agree to cover all of your closing costs and not increase your loan balance. In this case, though, the lender charges a slightly higher interest rate on the loan. 

Even though you don’t pay anything upfront, you end up paying more for your loan in the long run.

When Does a No-Cost Mortgage/Refinance Make Sense?

Before choosing a no-cost mortgage or refinance, crunch the numbers to make sure this option makes sense from a financial standpoint. 

If you’re interested in a no-cost mortgage (in exchange for a slightly higher interest rate), get a rate quote based on paying closing costs yourself, and the lender paying these costs for you. 

Determine how much extra interest you’ll pay over the life of the loan with the higher rate.

And then compare this with what you owe in closing costs.

After doing the math, you may conclude that it’s cheaper to pay the closing costs upfront if you’re in a position to do so.

If your mortgage lender offers to wrap your closing costs into the mortgage balance, this is only an option if your property has enough equity.

As a general rule of thumb, the lender will not lend more than a property is worth.

So if you’re getting a loan for $210,000 and interested in wrapping $5,000 into the mortgage balance to cover closing costs, your property must be worth at least $215,000.

Alternatives to a No-Cost Mortgage

A no-cost mortgage isn’t the only option when you’re short on cash, so ask your lender about alternatives.

Financial gifts

If you’re buying a home and don’t have enough cash for closing costs, see if your mortgage loan program allows financial gifts.

If so, a relative can gift 100% or a percentage of your down payment and/or closing costs. This helps relieve some of the financial burden of a home purchase.

To be eligible, the money you receive must be a gift, and not a loan. Therefore, the person providing the financial gift shouldn’t expect repayment.

Home equity loans or HELOC

You can also look into other home equity options. Some people refinance and cash-out some their equity. This money is often used for debt consolidation, home improvements, etc. 

But refinancing isn’t the only way to tap your equity. There’s also the option of a home equity line of credit or a home equity loan.

With a home equity loan, you get a lump sum of cash for just about any purpose.

A home equity line of credit (HELOC), on the other hand, gives you access to a line of credit on an as-needed basis. 

These options are worth consideration.

They both involve no closing costs or very little closing costs, making them an affordable alternative to refinancing.

Final Word

No-cost mortgage loans can make purchasing or refinancing a home easier and cheaper. But make sure you understand exactly how this option works. 

Sure, you’re able to get a loan with little to nothing out-of-pocket. But you’ll end up paying for lender and third-party fees one way or another. This might be in the form of a higher mortgage rate or a higher loan balance.