Image source: Getty Images

Buying or refinancing a home? You may want to consider a "no-closing-cost" mortgage. While this type of mortgage generally does have a higher interest rate than a traditional mortgage, it could make your purchase a lot more affordable upfront since the lender will pay some or all of the closing costs associated with completing the home loan.

Of course, there are good and bad parts for this option, and it doesn't make sense for every situation. While it could save the borrower thousands of dollars up front, it will also mean higher monthly payments and potentially a higher total amount paid over the life of the loan. Here's how a no-closing-cost mortgage works, and how to decide if it's a good option for you.

How a no-closing-cost mortgage works

Closing costs are made up of appraisal fees, recording fees, and various other services that must be performed during the home buying process. For an average buyer, closing costs are usually around 2-5% of the total loan amount, and are expected to be paid up front by the buyer at the time of purchase. If you are getting a home loan for $300,000, the added $15,000 in closing costs (as they would be at 5% closing costs) would be a hard pill to swallow, especially when that money might be needed for small renovations before the home is ready to move into. 

To make the initial purchase of the home more bearable, many lenders offer a "no-closing-cost" option by agreeing to pay some or all of the closing costs on behalf of the buyer. In exchange, the lender either rolls the closing costs into the total loan amount, or chargers a slightly higher interest fee on the loan so that they will recoup that money over the life of the loan.

Is this mortgage option right for you?

A home mortgage is one of the biggest financial decisions most people will ever make, so it makes sense to check to see if this option could potentially save you (or cost you) thousands of dollars. The below calculator is a great tool to figure out if a no-closing-cost mortgage is right for your situation.

 

* Calculator is for estimation purposes only, and is not financial planning or advice. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and should not be relied on as a substitute for a financial advisor or a tax professional.

Even after going through these calculations, it can be tough to decide on if this type of mortgage is right for you. Here are few key points to consider while trying to decide.

1. Do you have enough money for closing costs?

Many people are eligible for a home loan only if they can agree to a certain amount as a down payment. For some, that might be the bulk of their savings and there simply won't be enough left over to also pay hefty closing costs. If that's the case (or you prefer not to dip into the emergency fund to do so), then choosing a no-closing-cost mortgage may be the only option that allows you to actually go through with the purchase, in which case you'd have to decide if the price is worth it, or if perhaps you should continue to save before buying. 

Doing the math to choose the best mortgage option. Image source: Getty Images

2. How long are you planning to be in the home?

Assuming you have enough to pay closing costs up front, the next question determines a "break even" point based of how long you will be in the home vs. the added monthly payments. In the example with a $300,000 home, the difference between a 4% interest rate and 4.5% interest rate would be about $100 a month on a 30 year loan. 

If closing costs are $10,000, then it would take 100 months, or 8.3 years, to break even. After this point, you would be paying more in added monthly interest expense than you saved in not paying closing costs. If you are fairly certain that you will be selling your home again before that time (or will be able to refinance at a lower rate), it might make sense to choose the no-closing cost mortgage.

3. Is there an early repayment penalty clause in the loan contract?

If you choose a higher interest rate option thinking that you'll be able to pay off your loan ahead of your break even point -- be careful. Many mortgage contracts also include a penalty for early repayment of the loan. If your lender has this, it could make it harder to avoid paying closing costs up front without paying even more to the bank over the course of the loan, even if that loan period is cut short. 

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.