Financing Closing Costs Can Sometimes Be a Bad Idea

November 3, 2008, Revised November 15, 2008, September 3, 2009, September 10, 2010

Many mortgage borrowers are tempted to finance their closing costs, that is, add the costs to the loan amount. This could be attractive to borrowers who can earn high returns on their free cash, or those who don’t have any free cash. Financing closing costs is very costly, however, if the larger loan increases the price of the mortgage.

This will happen if the loan amount crosses a pricing notch point (PNP) – a loan amount at which the interest rate, points or mortgage insurance premium increases. Since any price increase will apply to the entire loan, not just the increment used to finance closing costs, it will make the increment extremely costly.

For example, suppose financing $8,000 in closing costs on a $400,000 loan takes the loan past a PNP where the mortgage insurance premium jumps by .25%. The additional premium amounts to $1020 in year one alone, of which $20 is on the $8,000 loan increase and $1,000 is on the original $400,000.

On conventional loans, PNPs in the ratio of loan amount to property value are 80%, 85%, 90%, 95% and 97%. As an example, if the $400,000 loan is 80-83% of value, adding closing costs of $8,000 to the loan won’t affect the price because the ratio will remain below 85%. But if the initial ratio was 84%, adding the $8,000 will bring the ratio above 85%, so the price of the loan will be higher. On FHAs, the only PNP in 2010 was 97%.

The conventional loan amount also has a PNP at the largest loan that can be purchased by Fannie Mae and Freddie Mac, called the conforming loan limit. Above the loan size maximum, the loan price will be higher. There used to be only one nationwide maximum, but now the maximums vary from county to county and range from $417,000 to $729,750. Since the agencies charge higher prices on conforming loans above $417,000 than on those of $417,000 and below, there are two loan size PNPs for every county that has a maximum above $417000. You can find the maximum for your county at

For a discussion of how financing of closing costs affects a refinance, see Finance Settlement Costs in Mortgage Refinance?

Where financing closing costs may penetrate a PNP "going up", thereby raising the price, increasing the down payment can penetrate a PNP "going down", thereby reducing the price. See A Great Investment in Loan Repayment.

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