What Are Closing Costs & How Do They Work?
So, you’ve found your dream home and settled on a price both you and the seller can agree upon. Great! You’re not done yet, though. There’s still the inevitable hurdle of—yes—closing costs. Closing costs are the expenses, over and above the price of the property, that buyers and sellers normally incur to complete a real estate transaction. You can’t get around them, but understanding how they work can help you lessen the blow. Though we touched on closing costs briefly in the last post, you may still have plenty of questions about closing costs. No worries! We’ll try to touch on some of the fine print today.
How do closing costs work, anyway?
Closing costs occur when the title of property is transferred from the seller to the buyer. The total dollar amount of closing costs depends on where the property is being sold and the value of the property being transferred. Homebuyers typically pay between 2% to 5% of the purchase price, but closing costs may be paid by either the seller or the buyer. A real estate transaction is a somewhat complex process with many players involved and numerous moving parts. Some states (and some loan products) require certain inspections beyond the basic inspection you pay directly to a home inspector of your choice. Then there are property and transfer taxes, as well as insurance coverage and various additional fees.
Lenders have to provide a loan estimate that reveals the closing costs on the property. Under the Real Estate Settlement Procedures Act, or RESPA, lenders are required by law to provide this estimate (also known as a good faith estimate) within three days of the lender taking a borrower’s loan application. At least three days prior to the closing, the lender should also provide a disclosure statement outlining all closing fees. Note that the listed fees may have changed from the loan estimate.
What are some examples of closing costs?
Trust us, there are plenty! This list isn’t exhaustive. Be sure to consult with your lender if you need further explanation of a fee or cost. Knowledge is power!
A fee charged by the lender to process your mortgage application. Ask the lender for details before applying for a mortgage.
A fee charged by a real estate attorney to prepare and review home purchase agreements and contracts. Not all states require an attorney to handle a real estate transaction.
Also known as an “escrow fee,” this is paid to the party who handles the closing: the title company, escrow company or an attorney, depending on state law.
If you’re signing paper documents, this fee helps expedite their transportation. If the closing is done digitally, you might not pay this fee.
Credit Report Fee
A charge ($15 to $30) from a lender to pull your credit reports from the three main reporting bureaus. Some lenders might not charge this fee because they get a discount from the reporting agencies.
Some lenders require you to deposit two months of property tax and mortgage insurance payments at closing.
Flood Determination and Monitoring Fee
A fee charged to a certified flood inspector to determine whether the property is in a flood zone, which requires flood insurance (separate from your homeowner’s insurance policy). Part of the fee includes ongoing observation to monitor changes in the property’s flood status.
Homeowners’ Association Transfer Fee
If you buy a condo, townhouse, or property in a planned development, you must join that community’s homeowners’ association. This is the transfer fee that covers the costs of switching ownership, such as documents. Whether the seller or buyer pays the fee may or may not be in the contract; you should check in advance. The seller should provide documentation showing HOA dues amounts and a copy of the HOA’s financial statements, notices and minutes. Ask to see these documents, as well as the bylaws, covenants, conditions, and restrictions (or CC&Rs) and rules of the HOA before you buy the property to ensure it’s in good financial standing and it’s a place you want to live.
A lender usually requires prepayment of the first year’s insurance premium at closing.
Lender’s Title Insurance
An up-front, one-time fee paid to the title company that protects a lender if an ownership dispute or lien arises that it didn’t find in the title search.
Points (or “discount points”) refer to an optional, up-front payment to the lender to reduce the interest rate on your loan and thereby lower your monthly payment. One point equals 1% of the loan amount. In a low-rate environment, this might not save you much money.
Owner’s Title Insurance
This policy protects you in the event someone challenges your ownership of the home. It is usually optional but highly recommended by legal experts.
This charge covers the lender’s administrative costs to process your fee and is typically 1% of the loan amount. Some lenders do not charge origination fees, but usually, charge a higher interest rate to cover costs.
A fee that covers the cost of a professional pest inspection for termites, dry rot or other pest-related damage. Some states and some government-insured loans require the inspection.
Prepaid Daily Interest Charges
A payment to cover any interest on your mortgage that will accrue from the date of closing until the date of your first mortgage payment.
Private Mortgage Insurance (PMI)
If your down payment is less than 20%, your lender might require PMI. In this case you may be required to make the first month’s PMI payment at closing.
Property Appraisal Fee
A required fee paid to a professional property appraisal company to assess the home’s fair market value used to determine your loan-to-value (LTV) ratio.
At closing, expect to pay any property taxes that are due within 60 days of the home purchase.
Rate Lock Fee
A fee charged by the lender for guaranteeing you a certain interest rate for a limited period of time, typically from the time you receive a preapproval until closing.
A fee charged by your local recording office, usually city or county, for the recording of public land records.
A fee charged by a surveying company to check property lines and shared fences to confirm a property’s boundaries.
Tax Monitoring and Tax Status Research Fees
A third-party fee to keep tabs on your property tax payments and to notify your lender of any issues with your property tax payments, such as late or failed payments.
Title Search Fee
A fee charged by the title company to analyze public property records for any ownership discrepancies. The title company searches deed records and ensure that no outstanding ownership disputes or liens exist on the property.
A tax levied to transfer the title from the seller to the buyer.
A fee charged by the lender for underwriting your loan. Underwriting is the research process of verifying your financial information, income, employment and credit for final loan approval.
Can you reduce your closing costs?
It might feel like you can’t afford all of these fees on top of the down payment, moving expenses, and repairs to your new home. However, there are ways to negotiate these fees. You’re not likely to avoid paying closing costs entirely. While some costs such as transfer taxes and property taxes can’t be changed, there are several ways to lower your out-of-pocket expenses at the closing.
This applies to lenders and third-party services, such as homeowner’s insurance policies and title companies. Many homebuyers don’t realize they can save significant money on closing costs if they compare fees from lender to lender. Also, you don’t have to use the title company, pest inspector or homeowner’s insurance agent your lender suggests. Do some homework, and you could save some serious cash on those fees.
Schedule closing at the end of the month.
If cash flow is an issue, try to negotiate the settlement date, which can affect the amount you pay in closing costs. A closing date near or at the end of the month helps cut down on prepaid daily interest charges. A lender can run this scenario for you to figure out how much you might save.
Appeal to the seller for help.
You might be able to get a seller to either lower the purchase price or to cover a portion (or all – if you’re really lucky) of your closing costs. This is more likely if the seller is motivated and the home has been on the market for a long time with few offers. In many hot housing markets, though, conditions favor sellers so you might get pushback or a flat-out “no” if you ask for a seller’s help. It doesn’t hurt to ask, but in a competitive market buyer tend to avoid this because you risk looking weaker as a prospective buyer.
Compare the loan estimate and closing disclosure forms.
When you get your initial loan estimate, compare them carefully—like you would with an itemized medical bill. If you’re unsure about what a fee entails or why it’s being charged, ask the lender to clarify. A lender who can’t explain a fee or pushes back when queried should be a red flag. If you suspect a lender is adding on unnecessary fees, known as “junk fees,” on your loan, speak up. Ask the lender to remove or reduce fees if you notice duplication. Comparison shopping can be your ally in reducing closing costs, as well as finding competitive terms and rates. Be especially wary of excessive processing and documentation fees.
Roll closing costs into your mortgage.
In some instances, lenders will offer to pay your closing costs or roll them into your loan. You’re not off the hook; lenders tend to charge higher interest rates to pay themselves for absorbing your closing fees, which means you ultimately end up paying interest on your loan – and on closing costs. Think carefully on this one and use it as a last resort only.
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