The Big 'Catch' Associated With No-Closing-Cost Mortgages

No matter how you slice it, buying a home can take a bite out of your bank account. In addition to a down payment, home buyers must pay closing costs -- typically 3% to 6% of the loan amount. That means adding $9,000 to $18,000 to the cost of borrowing $300,000. It's not always a chunk of change buyers have at their disposal, which is where no-closing-cost mortgages come in.

Understanding closing costs

As mentioned, closing costs vary, depending on many factors. The good news is that they don't pop up from a dark corner, like an ax murderer in a horror movie. Instead, by law, your mortgage lender must give you an estimate at least three business days before you close on the mortgage (this information is known as a closing disclosure). Here's some of what closing costs typically include:

• Home appraisal fees
• Title insurance
• Mortgage origination fees
• Application fees
• Processing fees
• Property taxes
• Homeowners insurance

If you're a home buyer, particularly a first-time home buyer, closing costs can seem overwhelming.

And that's where no-closing-cost mortgages come in

Mortgage lenders sometimes advertise no-closing-cost mortgages to appeal to home buyers short on cash. However, buyers who apply for a no-closing-cost mortgage must meet the same loan criteria as any other home buyer. The entire appeal is avoiding closing costs.

The problem is there is no avoiding closing costs. A buyer may not have to pay them upfront, but they will end up covering the cost one way or another.

Here's how it works:

• A home buyer applies for a no-closing-cost mortgage.
• The application is approved, and a closing date is set.
• Rather than charge the home buyer closing costs upfront, the lender finds another way to recoup the funds.
• Some lenders roll closing costs into the loan. For example, if a buyer borrows $300,000, they may end up with a loan for $318,000 instead. The critical thing to remember is that the buyer will now spend the entire mortgage paying interest on the closing costs rolled into the loan.
• Another lender may cover the closing costs, but hike up the interest rate. Let's say the going interest rate on the mortgage is 6%. The lender may raise the rate to 6.5%. So, instead of paying $1,799 (principal and interest) for 30 years, the home buyer now pays $1,896 monthly for 30 years. In total, the no-closing-cost mortgage costs the buyer $34,560.

A savvy buyer may take out a no-closing-cost mortgage with the intention of paying the house off early and getting out from under the original mortgage. The problem is lenders sometimes add a prepayment penalty to no-closing-cost mortgages, just in case a buyer tries to refinance. In other words, a lender sets up the contract in a way that ensures it will recoup its costs.

Your move

If you're in the market for a home but are concerned about closing costs, take your time with the details of a no-closing-cost loan. Read the contract carefully, looking specifically for the following:

• How does the lender plan to recoup its money? Is it proposing a higher interest rate, or will it roll the closing costs into the loan to be paid off over time?
• Has the lender written in a prepayment penalty to discourage you from paying off the original loan and refinancing the house?

Once you understand how the loan is set up, crunch the numbers. The extra cost spread across the years more than makes up for not having to pay closing costs today. Or, you may find that your best bet is to scrape together the closing costs now to save yourself money throughout the life of the loan.

Finally, consider one of these three options:

1. Negotiate with the lender. Closing costs are not engraved in stone. Let the lender know you need to get costs down and ask which fees can be reduced or waived. Usually, lender application and origination fees are the easiest to cut.
2. Look at home buyer programs. If you're a first-time buyer, you'll find that cities and states frequently offer first-time home buyer programs. These programs may include grants and other financial assistance, including help with down payment and closing costs. If you need help figuring out where to look, begin by asking your real estate agent.
3. Consider working with another lender. Some lenders offer "no-fee loans." In this case, no-fee means that the lender reduces closing costs by cutting any expenses that would have gone directly to the lender. You'll still need to pay closing costs, but the amount will be reduced. If you go this route, go over the contract with a fine-toothed comb to ensure the lender doesn't try to recoup its cost by jacking up the cost of the loan in another way.

Buying a home is an exciting time in life. But it's a good idea to postpone the celebration until you've taken steps to leave as much money as possible in your bank account.