Why You Shouldn't Roll Closing Costs Into Your Mortgage

There's a host of downsides to rolling closing costs into your mortgage.

When you get a new mortgage or a refinance loan, you'll usually need to pay closing costs. These are usually around 2% to 5% of your home's value, and they can add up to several thousand dollars.

Typically, when you're getting a new mortgage, you have to pay these costs out of pocket up front. (There are some exceptions for certain types of fees for government-backed loans.) However, when you refinance a mortgage, some lenders let you roll these costs into your new loan. That means if you were going to borrow $200,000 and pay $6,000 in closing costs, you'd instead borrow $206,000 and pay no closing costs up front.

This may sound like an attractive option since you don't need to come up with several thousand dollars to close on a refinance loan. But, in many cases, it's actually a far better idea to pay the closing costs up front and be done with them rather than dragging out repayment over time. Here's why.

The downsides of rolling closing costs into your mortgage refinance loan

When you roll your closing costs into your mortgage refinance loan, you'll have to pay interest on that money the entire time you're paying off your home loan. This can actually make these fees more expensive.

Consider the difference between that $200,000 loan and the $206,000 loan mentioned above. If you took out a 30-year $200,000 loan at 3.25%, your monthly payment would be $870 and your total interest costs would be $113,428 over the life of the loan. But if you borrowed $206,000 because you tacked on closing costs, monthly payments would be $897 and you'd pay $116,831 in total interest over the life of the loan. Instead of paying $6,000 up front, you'd pay an extra $27 per month every month for three decades. That means you'd end up spending about $9,700 on closing costs and the interest paid on them.

Increasing the amount you borrow and your monthly payment could also make loan approval more difficult. That could be an especially big issue if you're close to exceeding your lender's allowable debt-to-income ratio or if you're refinancing a loan with a balance close to 80% of your home's current value.

See, lenders typically want your total monthly debt payments -- including housing costs -- to be below a certain percentage of your monthly income. By making your payment more expensive, it's harder to keep your payments low enough to qualify for a loan. And if you borrow more than 80% of what your home is worth, you usually have to pay private mortgage insurance to protect the lender in case you fall behind on payments.

You don't want to jeopardize your chances of loan approval or making your loan more expensive over time just to avoid paying closing costs when you refinance. Instead, it's worth considering saving up the money so you can cover closing costs when you get the loan. You'll maximize the amount your refinance saves you by not making your loan bigger, and you can avoid potential problems with getting your new home loan approved.