Wednesday, 13 November 2019

No-Closing-Cost Mortgages: Understand the Risks

No-Closing-Cost Mortgages: Understand the Risks
20 Jan
10:19
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If you’re a savvy shopper, you’re probably always looking for ways to spend as little money as possible. But when it comes to paying closing costs for your new house, spending less may not be the best idea. Closing costs are the assortment of fees that a homebuyer pays when closing on the transaction. They could include such charges as the cost of the appraisal, title insurance and tax service-provider fees. They also could include fees that you pay in advance, such as property taxes and homeowners insurance.

If that sounds like an expensive proposition, you’re right. Closing costs add approximately $6,250 to the median house purchase in the United States, according to an October 2018 analysis by first-time homebuying website, RealEstate.com and small-business marketplace, Thumbtack. Add that to the down payment, which could be as low as 3.5% of the home’s purchase price, or a minimum of 20% to avoid mortgage insurance, and you’re talking about some serious cash.

So if someone told you that you qualified for a “no-closing-cost mortgage,” it’s easy to see why that might sound appealing. However, before signing on the dotted line, you should understand the risks.

The idea of paying no closing costs sounds great and it catches people’s attention, said Larry Locke, a mortgage broker with Pro-Funders Inc., in Murrieta, Calif. “However, there’s no such thing as a free lunch. The cost has to be dealt with somewhere.”

A no-closing-cost mortgage is not, in fact, free. Instead, it’s a way of structuring a mortgage loan so that the lender recoups the closing-cost fees in one of two ways: either by charging a higher interest rate on the mortgage than it would otherwise, or by adding the closing costs to the amount of your loan. With either option, you can avoid out-of-pocket payment for the closing costs. Instead, the closing-cost fees will be spread out — and you will pay them — over the life of the loan.

Is a no-closing-cost mortgage a good option for first-time homebuyers?

You may be wondering if a no-closing-cost mortgage is the right option for you. It depends. There are some situations when a no-closing-cost mortgage might be ideal.

You don’t have a lot of cash on hand. Many first-time homebuyers find it extremely challenging to save enough money for a down payment and closing costs. If you don’t have a lot of savings, a no-closing-cost mortgage could be your only option for becoming a homeowner now rather than waiting until you are able to save more money.

You need your cash for other financial priorities. Even if you do have the money to spend on the down payment and closing costs, you may decide that you’d rather use your money for something else that’s more urgent. Maybe you have medical expenses. Perhaps you’d rather have the peace of mind that a large emergency fund brings. Whatever your reason, you may decide that you’d rather not tie up all of your money in buying a house.

You plan to sell the house soon. There’s another situation in which paying no closing costs upfront might make sense. If the lender covers the closing costs on a 30-year mortgage by giving you a higher interest rate, those closing costs will be stretched out over the life of the loan in the form of higher interest. However, you won’t be making those interest payments all at once. Instead, you’ll be paying a little toward them each month for the next 30 years. On the other hand, if you pay the closing costs upfront, you’ll pay for the closing costs immediately. If you sell the house in the first few years after you buy it, you may end up spending more by paying the closing costs upfront than you would have spent on the additional interest for those few initial years.

“If a homebuyer is only going to stay in the house five years, the financial harm of a higher interest rate is less impactful than if they’re going to stay in that house for 30 years. It amplifies out over time,” Locke said.

Say you’re considering two mortgage offers for a $250,000, 30-year fixed rate loan. Lender A offers you a conventional mortgage loan with a 4.5% interest rate and $3,000 in closing-cost fees. Lender B offers you a no-cost mortgage with a 5% interest rate. While the loan with the higher interest rate would save you money in closing costs, it would cost $75.34 more per month, or $904.08 per year. For the first three years of the loan, you’ll spend less overall with the no-closing-cost loan. However, by the end of Year Four, you would have spent approximately $3,616.32 more in mortgage payments with the no-closing-cost loan — $600 more than you saved initially in closing costs. If you pay the closing costs upfront rather than take the no-closing-cost option, you’ll come out ahead once you are three years and four months into the loan.

It’s also important to consider the cons of taking out a no-closing-cost mortgage.

You may spend more money on the loan over time. If you’re planning to stay in the house for 30 years, a higher interest rate means you will spend significantly more in interest over the mortgage term. Even if the lender takes care of closing costs by wrapping them into the loan rather than charging you a higher interest rate, you’ll be financing the closing costs, so you’ll be paying interest on them, rather than simply paying them upfront.

Your monthly payments may be higher. Whether you’re financing the closing costs by rolling them into the loan, or you agree to a higher interest rate to cover the costs, your monthly mortgage payments may be higher with a no-closing-cost mortgage than they would be otherwise. If your budget is already tight, a larger mortgage payment might not be a good option for you.

There are also other factors to consider whenever you shop around for a mortgage loan and compare multiple offerings.

  • Always understand all fees that you will be responsible for either at closing or throughout the life of the loan. You can find a listing of those fees in the Closing Disclosure, a document sent by your lender that details the loan. If you don’t understand any of the charges, ask the lender to explain them.
  • Check for prepayment penalties. Some loans require you to pay a specified amount if you pay off the loan early or refinance. In some cases, you may even be charged a prepayment penalty if you sell the house before the full term of the loan is up. If you’re considering a loan with a prepayment penalty, make sure you understand what circumstances would trigger the penalty, and how much you’d be expected to pay.

Alternative lower-cost loans

If you don’t have a lot of cash available for buying a house, there are other ways that you can decrease the amount of money you need upfront. Rather than take out a no-closing-cost mortgage, you can look for a loan program that lets you make a low down payment to get the financial relief that you need.

FHA loans are offered by private lenders and insured by the Federal Housing Administration (FHA). Under the FHA loan program, you can put down as little as 3.5% on a house.

VA loans are offered by private lenders and guaranteed by the U.S. Department of Veterans Affairs (VA). The program, which is available to veterans, servicemembers and eligible surviving spouses, may offer loans that require no down payment.

USDA loans are backed by the U.S. Department of Agriculture (USDA) and designated for borrowers in rural and suburban parts of the country, as defined by the agency. Under the USDA loan program, homebuyers may be able to take out a loan while making no down payment.

If becoming a homeowner is important to you, a shortage of cash doesn’t have to derail your plans. For some homebuyers, particularly those who don’t plan to stay in the house long, a no-closing-cost mortgage could be a good move. However, make sure you understand the risks and the overall costs that come with them — or any other low-cost alternative.

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Tamara Holmes

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