Is it Better to Pay Closing Costs Upfront OR Do a Zero Closing Cost Loan?

December 6, 2016

As if scraping together a down payment on a new home weren’t already a big enough task, you also have to cover closing costs. These add many thousand dollars to the out-of-pocket cost of purchasing a home. You can either pay closing costs upfront or do a zero closing cost loan.

Which is the better strategy? It all depends on your personal circumstances.

What Do Closing Costs Usually Run?

Closing costs vary from one region of the country to another but generally range between 2% and 3% of the new mortgage. If the new loan amount is $200,000, and the closing costs come to 2.5%, then the total cost will be $5,000.

It’s important to understand however that closing costs are not based on a flat percentage fee. Instead, they are comprised of some fees that fall somewhere between the 2% and 3% range. Our use of percentages for closing costs is simply to avoid a lot of tedious math calculations.

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Closing costs are a wide variety of fees commonly including the application fee, appraisal fee, title search, title insurance, attorney fees, survey, home inspection, flood certification, recording fees, state/county/municipal mortgage taxes, and a host of lesser fees.

Also included in the mix are “points.” One point is equal to 1% of the loan. They can be charged as an origination fee, which is compensation to the lender, or as a discount fee, which is used to reduce your interest rate. Not all lenders charge points, and it mostly depends upon industry practices in your area or the selection of certain loan types.

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How a Zero Closing Cost Loan Works

Zero closing cost arrangements are frequently referred to as lender paid closing costs. Internally, this is referred to as premium pricing because it involves the lender charging you a higher interest rate in exchange for paying the closing costs on your behalf.

Generally speaking, the lender can pay 1% of the loan amount toward your closing costs, in exchange for increasing the interest on your loan by about 1/8% (or 0.125%), though it could be as high as 1/4% (or 0.250%) at certain price points.

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Let’s say that you are taking a $250,000 mortgage that will require $5,000 closing. You don’t want to pay those closing costs upfront, so you asked the lender for a zero closing cost loan.

The lender increases interest rate that you will pay by 0.250%, resulting in an interest rate of 4.00%, rather than the popularly advertised rate of 3.75%. In exchange, they will cover closing costs equal to 2% of the new mortgage amount. This will cover the entire $5,000 closing costs that need to be paid on the new loan.

A Zero Closing Cost Loan Minimizes Cash Upfront

The obvious advantage to a zero closing cost loan is that it will reduce the amount of cash needed to close down to the amount of the down payment. You will have to pay a slightly higher interest rate on the mortgage, but then you will have minimized the amount of cash that you will need to come up with.

Paying Closing Costs Upfront Gets You the Lowest Interest Rate

The advantage to paying closing costs upfront and out of your own pocket is that you will get the lowest interest rate available. Continuing the example from above, if you need a $250,000 mortgage, and you take the low rate of 3.75%, your monthly payment will be $1,158 on a 30 year fixed rate mortgage.

For comparison sake, if instead, you go with a zero closing cost loan, with an interest rate of 4.0%, the monthly payment on a $250,000 mortgage will be $1,194 on a 30 year fixed rate mortgage.

Paying the closing costs upfront will save you $36 per month, or $432 per year.

Now if you want to determine the advantage mathematically, you can divide the amount of the closing costs you will need to pay by the amount of money you will save each year by paying the closing costs upfront:

$5,000 / $432 = 11.574
What this calculation shows is that the benefit of paying the closing costs upfront and getting the lowest rate will not begin to work to your advantage until the loan has been in place for a little over 11.5 years.

Why is that important?

If you think that you will either sell the property or refinance it in less than 11.5 years, you will be better off going with a zero closing cost loan. The benefit for taking the lowest interest rate – and paying the closing costs upfront – will not be realized for at least 11.5 years.

Which is More Important to You – Lowest Rate or Minimal Cash Upfront?

Whether you should pay the closing costs upfront or do a zero closing cost loan really depends on what’s most important to you. Do you want the absolute minimum interest rate and monthly payment, or do you want the absolute minimum amount of cash upfront?

You should also do the calculation dividing the closing costs by the annual amount of savings on the interest rate that was demonstrated earlier. And once again, if you expect that you will either sell the property or refinance in less than the number of years indicated, you may want to go with the zero closing cost option.

But There is a Third Way that Can Accomplish Both Goals

As luck would have it, you don’t have to choose between either paying the closing costs upfront or doing a zero closing cost loan – there is a third option. And that is to have the property seller pay the closing costs. Under that arrangement, you can get the lowest interest rate possible, and still not have to pay the closing costs upfront out of your own resources.

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Under current mortgage regulations, the seller is permitted to pay your closing costs up to a certain limit. On FHA mortgages, the seller can pay up to 6% of the purchase price of the property toward closing costs. On VA loans the seller can pay up to 4%. And on conventional mortgages, the seller can pay up to 3% of the purchase price or the value of the property, if the mortgage amount exceeds 90% of the property value or 6%, if the mortgage is less than 90% of the property value.

So when it comes to closing costs, you actually have three options – pay the closing costs upfront and get the lowest interest rate, pay a higher rate and have zero closing costs, or have the seller pay the closing costs, allowing you to get the lowest interest rate without having to pay any closing costs at all.

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