No Closing Cost Refinance | Insider’s Guide to Benefits, Pros & Cons
What is a No Closing Cost Refinance?
A no closing cost refinance is a transaction that replaces your existing mortgage with a new one, with no out-of-pocket costs. A no-cost refinance is used to lower monthly mortgage payments or cash-out home equity (or sometimes both).
Closing costs can be an obstacle for folks looking to refinance their mortgage. Closing costs are not trivial; they run 3% to 6% of the loan amount. And there are many of them. Do you remember the list of fees from your original mortgage? You paid for things like taxes, insurance escrows, underwriting, origination, title, administrative and appraisal fees. When combined, theses costs typically reach several thousand dollars.
For the average borrower, putting together the dough to cover closing costs can be difficult. And all you really wanted to do in the first place was save money…not spend it. Well, that’s why a no closing cost refinances exist.
Let’s be clear, there are no magic tricks here. Closing costs don’t just disappear. What a ‘no cost refinance’ really means is that loan fees are repaid over time instead of all-at-once (out-of-pocket). Here are the two ways to make that happen:
- Roll closing costs into the mortgage
- Lender pays the closing costs
Reasons to Get a No Closing Cost Refinance
In the mortgage industry, refinancing activity happens in good times, bad times and in high interest or low interest periods alike. That’s because consumers will always have a reason to refinance, including the desire to:
- Lower a monthly mortgage payment
- Cancel FHA mortgage insurance
- Pay off the mortgage faster by reducing the term
- Convert an ARM to a fixed-rate mortgage
- Settle a divorce
- Tap into home equity (cash-out)
- Consolidate debt
No Cost Refinance Options
Let’s examine the refinance options side-by-side, starting with the borrower paying closing costs out-of-pocket. That will give us a baseline to which we can compare the no-cost refinance options.
Here’s the hypothetical deal. Say you wanted to refinance a home worth $700,000, leaving a $500,000 loan balance. The closing costs are $15,000.
You pay the closing costs. The lender offers a 4.25% interest rate. The monthly principal and interest (P&I) portion of the mortgage payment is $2,460 per month.
Closing Costs Added to Principal
Instead of paying out-of-pocket, you decide to roll the closing costs into the new loan, adding them to the loan balance. Continuing with the same numerical inputs, we’ll add $15,000 to the loan balance, making the new total loan amount $515,000. The interest rate is still 4.25%. The revised monthly P&I amount is $2,533.
Lender-Paid Closing Costs
Another option is to have the lender pay the closing costs. When the loan-to-value (LTV) is tight, there may not be enough room roll closing costs into the principal balance. In this situation, having the lender pay the loan fees them can make a lot of sense. And they’re happy to do so. The loan will carry a higher interest rate, or premium, to make this happen.
Continuing with our same hypothetical refinance, this time the lender charges 4.75% interest rate (0.50% higher) on the $500,000 loan balance. This monthly P&I payment comes to $2,608.
No Cost Refinance Breakeven Point
You can see how the monthly P&I portion changes depending upon path one takes to deal with the closing costs. To recap the monthly payments:
- $2,460 monthly P&I when buyer pays
- $2,533 monthly P&I when added to loan balance
- $2,608 monthly P&I when lender pays
What do these numbers mean over the long run? For zero-cost refinancing, where is the breakeven point?
The total cost is determined, in part, by how long the borrower lives in the home. At some point in the future, borrowers could end up paying more than the $15,000 tab for the closing costs. Lower monthly payments do not always mean the lowest total cost.
Let’s compute the total cost, using the same hypothetical $500,000 mortgage refinance example above. Remember, we’ll be modeling our number off of 4.25% and 4.75% interest rates as well as $500,000 and $515,000 principal balances.
- If the borrower pays $15,000 closing costs out-of-pocket, then the monthly payment is $2,460. This is the baseline.
- If the $15,000 is added to the loan balance, then the monthly payment is $2,533. That’s an extra $74 per month. At that rate, it takes 203 months (nearly 17 years) to pay the $15,000. Any payments made after that point means the borrower is paying more than the original $15,000 closing costs.
- If the $15,000 is paid by the lender, and the interest rate is bumped up, then the borrower pays $2,608 per month. That’s $149 more than the baseline. It takes 101 months (a little over 8 years) to pay $15,000. Any payments made after 101 months will be money spent in excess of the original $15,000.
It’s not always easy to know how long you will live in a home. Young families grow and upgrade from their first home to a bigger one. Retired people tend to downgrade to a smaller home or buy a second home in sunnier places.
But there is a general framework for thinking about breakeven points and no-cost refinancing. If you know for sure that you will only stay in the home 3 to 5 years, a no-cost refinance is probably going to save you money. Here are some general guidelines:
- The more time a borrower stays in a home, the more likely their payments will eventually exceed the total closing cost amount.
- The less time a borrower stays in a home, the more likely their payments will stay below the total closing cost amount.
You can run the numbers on our mortgage calculator to find your breakeven point.
No Closing Cost Refinance FAQs
When is a no closing cost refinance a good idea?
Your circumstances will dictate whether refinancing is a good idea. Here are three reasons you may benefit from it.
1. If interest rates have gone down since you took out your original mortgage, refinancing could lower your mortgage payment. The new loan will carry today’s lower rate, thus the interest portion of your monthly mortgage payment will be lower.
2. Mortgage interest rates are determined by several risk factors such as the property’s loan-to-value (LTV) ratio and your credit score. If your credit score has gone up, you may be eligible for a lower interest rate.
3. If you’d like to change the type of mortgage you have, refinancing is really the only way to make the switch. You can shorten the term, say from 30-year term to a 15-year term. You can create a predictable monthly mortgage payment amount by converting an Adjustable Rate Mortgage (ARM) to a Fixed-Rate Mortgage (FRM).
When is a no-cost refinance a bad idea?
Here are three reasons you probably would not benefit from a mortgage refinance.
1. If you’ve had your mortgage for a long time, say 10 years, the portion of your monthly payment applied to the principal balance today is much higher than the first couple years of your loan. To refinance at this point when reset the mortgage, taking you back to the days where most of your monthly payment applied to the interest.
2. If your current mortgage has a prepayment penalty, those fees need to be included in the breakeven point calculation.
3. If you plan to move in the next few years, there’s less likelihood of realizing any cost savings from a no-cost refinance.
Can I refinance my FHA loan with no closing costs out of pocket?
Yes. And one of the best ways to handle this is to get a FHA Streamline Refinance. You’ll knock off a couple fees right off the top because property appraisals and credit checks are not required.
Keep in mind, the FHA streamline does not allow cash-out for any reason, even if you’re looking to make a few home improvements. However, another option – the FHA 203(k) Streamline Refinance – does allow cash-out for home improvements made by a HUD-approved contractor.
What about a no closing cost refinance for my VA loan?
Just like the FHA Streamline above, the VA Streamline Refinance (IRRRL) also eliminates the need for appraisals or borrower credit checks. Eliminated those fees will knock about $800 off the closing costs.