- April 28, 2017
- Posted by: steve
- Categories: closing costs, mortgage articles
A no closing cost refinance may sound great, but is it actually the right option for you? Read here to get more information on no closing cost refinancing.
Interest rates have been at historical lows for the past several years, making it a great time to refinance your home mortgage. Many homeowners have taken advantage of this once in a lifetime opportunity to lock in low rates, reduce their monthly payments, and pay down other debts.
But the party is almost over.
Current economic conditions are ripe for mortgage interest rates to rise over the next several quarters. As refinance rates go up, the advantage begins to diminish. If you have been considering taking action, now is the time.
While refinancing in this economic environment may seem like a no-brainer, there are some important details to consider. One of the primary disadvantages of taking out a new loan is the costs associated with the process. These expenses, also known as closing costs, may include:
- Application fees
- Administrative fees
- Loan origination costs
- Appraisal expenses
- Title search fees
- Title insurance premiums
- Processing fees
- Tax service provider fees
- Government taxes
According to the Federal Reserve Board, closing costs can add up to about three to five percent of the loan amount. For a $300,000 loan, you can expect to add another $9,000 to $36,000 in expenses to the bottom line. This may seem intimidating, but you have several options for covering your closing costs.
Options for Paying Closing Costs
There are currently three main options for the payment of closing costs:
- Pay the expenses outright using cash on hand.
- Allow the lender to absorb the cost in exchange for increasing your loan’s interest rate.
- Add the closing costs to the principal balance of the loan, resulting in a higher monthly payment.
The first option is ideal for borrowers who have access to enough cash and plan to stay in their home for longer than five years. Paying your costs up front allows you to lock in a lower interest rate. Your monthly payment will also be less than it would be with the other options.
Many banks offer “no cost” loans, but the terms vary between lenders. Some institutions absorb all of your costs, others let you avoid paying them out of pocket, and still others waive only the lender fees. Borrowers should be aware that they will always end up paying for their closing costs, it’s simply a question of when and how.
The Math Behind a No Closing Cost Refinance
When you agree to pay a higher interest rate in exchange for avoiding closing costs, you are committing to paying more over the lifetime of the loan. This arrangement is typically termed the no closing cost refinance.
While it may not seem like much at first, adding as little as 0.50 percent to your interest rate can really add up over the lifetime of a loan. For a $300,000 traditional 30-year fixed mortgage, this equates to an additional $23,895 in interest expense.
Keeping your interest rate the same and bundling the closing costs onto the principal balance is also known as a no out of pocket cost refinance. Because the principal balance is increasing, your minimum monthly payment will be higher.
Consider the example of a $300,000 loan at a 30-year fixed rate of 4.25 percent. If you add $10,000 in closing costs to the principal, your required monthly mortgage payment would increase by $50. Over the lifetime of the loan, you would have paid an additional $18,000 to finance your $10,000 in closing costs.
It should be noted that not all lenders offer no closing costs refinance loans. Rates and terms will also vary depending on your credit score and the amount of equity that you have in your home. To qualify for a no out of pocket refinance you must have enough equity in your home to cover the additional loan amount.
Calculating Your Break-Even Point
To determine the best payment option for your closing costs, you need to calculate the number of years it would take you to recover the expense. Here are the steps:
- Start with the total monthly savings that you will receive after the refinance is complete. This is calculated by subtracting your new mortgage payment from the previous amount. For example, if your previous payment was $1,500 and your new payment is $1,200, you have a monthly savings of $300.
- Calculate your after-tax rate by subtracting your effective tax rate percentage from 100. A borrower in the 25% tax bracket would have an after-tax rate of 75%. If you aren’t sure of your current tax bracket, check with your tax preparer.
- Determine your after-tax savings. Continuing with this example, the after-tax savings would be $300 x 75%, or $225.
- Divide your total closing costs by your after-tax savings. This is the number of months that it would take you to break even on the closing costs you would pay with a traditional refinance loan. In this example, if closing costs were $10,000, it would take just over 44 months to break even ($10,000 / $225 = 44.44)
If you planned to keep your home for four years or longer, it might make sense to take out a traditional refinance loan and pay your closing costs outright. If you anticipate that you will sell the home or refinance again in less than 4 years, a no closing cost refinance might be a better option for you.
When Might a No Closing Cost Refinance Makes Sense?
There are some situations where it makes sense to choose a no closing cost option.
Insufficient Cash to Cover Closing Costs
A lack of cash on hand shouldn’t cost you the opportunity to refinance. If your current loan has a high interest rate or you need to refinance for other reasons, a no closing cost option may be right for you. Use a comprehensive cost calculator to compare your options.
Short Time Horizon
If don’t have enough information to calculate your break-even point, you can use the five-year rule of thumb. This states that if you plan on keeping your loan for five years or less then it may make sense to bundle in your closing costs. The resulting higher monthly payment or interest rate won’t impact you as much when it is only for a few years.
Immediate Cash Need
Some homeowners need to pull cash from their refinance to complete a remodel or pay off higher interest rate debt. In this case, letting the bank cover the closing costs could be to your advantage. Home remodels are also likely to add equity, which could give you an opportunity to refinance again in the future.
When Should a No Closing Cost Refinance be Avoided?
If you plan to stay in your home for at least the number of months determined by your break-even analysis then you may be better off to pay your closing costs outright. While it may sting a little bit to have to drop down that much cash up front, you will likely save yourself a significant amount of money over the long run.
Best Practices When Considering a Refinance
The number one rule when considering any type of loan is to read the fine print. Some lenders will add a prepayment penalty to your loan to keep you from refinancing again before they have recouped their expenses. This should be avoided if you plan to sell or refinance again in the near future.
Your lender should be willing to provide you with a side-by-side comparison of all loan costs and terms for each financing option. This will help you to do an analysis and decide which one is right for your specific situation.
Within three days of receiving your loan application, the lender is required to provide you with a detailed loan estimate. Be sure to examine this document carefully to ensure that it matches what you have previously been told. Terms that should be listed on the estimate include:
- Closing costs
- Interest rate
- Monthly payment
- Tax and insurance estimates
- Details regarding potential changes to interest rates and payments
- Information regarding any special features like prepayment penalties or negative amortization
If you see or hear anything during the loan process that you don’t understand, do not be embarrassed to ask for further clarification. It helps to work with a qualified lender who is committed to providing a comfortable mortgage experience.
Loan Negotiation Tips
You will be in a better position to negotiate your loan terms if you have all of the pertinent information up front. It may help to start out by asking what the lowest possible interest rate is on a standard loan. This will make it easier to see the cost difference when you start to evaluate your options for a no closing cost refinance.
If you plan to pay your closing costs outright, many variables are eliminated. When you are simply comparing the interest rate of a loan it’s far easier to shop around and negotiate with lenders. Borrowers with simple loan contracts are more likely to get a good deal than those with a lot of variable loan terms.
Are you currently considering a refinance? If you would like help determining which type of loan is right for you, contact us today to schedule a consultation.