One of the myriad decisions facing home refinancers and, to some extent, home buyers is whether or not to pay the closing costs up front. The closing costs of a refinance loan can usually be added to the balance. This option is sometimes also available to buyers of new homes.

We look into the pros and cons of paying closing costs up front versus rolling them into the balance. First, let's see how much money we're talking about.

What Are Closing Costs?

Total closing costs in the United States average $5,749 this year, including taxes.¹ This constitutes 2% to 5% of the amount borrowed. Closing costs are service fees that borrowers pay the lender for setting up the refinance or mortgage. Some closing costs derive from third-party fees too, which the lender collects.

Unlike interest rates, which may vary only a fraction of a percentage point from lender to lender, the swing in closing costs is wide. Lenders set their own. Remember, 2% and 5% is a big gap. Zillow estimates that a median-priced home in 2020 costs $256,000, so closing costs might be as low as $5,000 (2%) or as high as $12,500 (5%).

This is why when comparing lenders, you should compare their annual percentage rates (APRs) instead of the bare interest rates. The APR includes closing costs and perhaps other fees, so it's a truer picture of what the loan will cost you in the end. Some lenders reflect all their fees in their APR, while others leave some fees out of it to seem more competitive. When comparing home loans, drill into each lender's APR to see what it does and does not include. It would be an unwelcome surprise to choose a lender based on a good, low APR only to find that hundreds of dollars in mandatory fees weren't reflected in it. You have a lot of wiggle room when it comes to APRs. Every lender makes up its own APR, and APRs are freely negotiable.

“Closing costs are all disclosed at the loan closing on the HUD-1 settlement sheet as required by TILA (Truth in Lending Act).”

   —Mortech, a Zillow company

Closing costs vary greatly by where you live. Motley Fool writer Amy Fontinelle found that Pennsylvanians pay the highest percentage of their home's price in closing costs at 4.88%, while residents of Colorado, Wyoming, Montana, and Indiana barely pay 1%.²

If your closing costs would be on the high side, not having to pay them up front could look like an attractive option. But it comes with drawbacks.

Pros & Cons of Rolling Closing Costs Into Your Balance

Financing your closing costs means they get added to the loan balance and you pay interest on them. That means more debt. If coming up with a decent down payment was financial strain enough, though, you could be relieved by the idea of not having to come up with closing costs as well. Sure, you expect your monthly payment to increase a bit if you finance the closing costs along with the rest of the loan, but what's a few dollars more every month when you're facing perhaps the biggest purchase of your life?

Overall, incurring less debt is usually the best idea in the long run. If you pay the closing costs up front, they're over with—they're in your rearview mirror. Tack them on to the balance of the refinance or mortgage, however, and you increase your debt and pay interest on them for the life of the loan.

For example, let's say you borrow $225,000 and the closing costs are $8,000 (3.56%). You have taken out a 30-year fixed-rate mortgage, the most common type in America. You have the choice of paying the closing costs out of pocket up front, which keeps the loan balance at $225,000, or rolling them into the loan, which increases the balance to $233,000.


Interest Paid Over 30 Years With & Without Closing Costs
BASE LOAN INT. RATE CLOSING TOTAL LOAN MO. PYMT TOTAL INTEREST
$225,000 2.95% Cash up front 225,000 $943 $114,319
$225,000 2.95% $8,000 233,000 $976 $118,384

If you choose to roll the closing costs into the loan, each month's payment increases $33 for 30 years; that's 360 payments. In the end you will have paid $4,065 in interest for the $8,000 closing costs, in effect paying 50% more than they would have cost up front.

You can see the futility in spending time negotiating the lowest closing costs, whittling $100 off them here, $200 off them there, only to roll them into your loan balance where they will cost you 50% more in the end. If you can swing it financially, you're better off paying them up front.

What's Different for Home Buyers?

Writing for the Mortgage Reports, Craig Berry says that home buyers (as opposed to refinancers) often don't have the option of rolling their closing costs into the mortgage.³ Instead, buyers of new homes usually have four ways to cover the closing costs:

  1. Pay all costs on closing day.
  2. Negotiate seller concessions, where the seller pays some or all of the costs. Sellers might go along with this to seal the deal, which today's tight housing market makes unlikely because they probably have other buyers lined up behind you.
  3. Agree to pay a higher interest rate if the lender absorbs some or all of the closing costs (known as lender credits). You still end up paying the closing costs to the lender but in the form of slightly higher interest.
  4. Pay closing costs with gift money, but be sure to document it properly.

Berry advises new home buyers to try to pay the closing costs up front. He adds that "by adding the closing costs to your new mortgage balance you are increasing the loan-to-value. By increasing the LTV, you are reducing the amount of equity in your home."

On the other hand, if you don't want to drain your savings account at closing time and you managed to get a very low interest rate, financing some or all of the closing costs could be your best move. It would leave you with a savings cushion for any unexpected new-home purchases and services, expenses that you might be tempted to put on a credit card.

Takeaways

  • Financing the closing costs can mean paying 50% more for them in the end.
  • Saving for closing costs alongside a down payment will let you pay them up front, incurring less debt.
  • Costs could be so high where you live that rolling closing costs into the loan is your most feasible option.