While most future homeowners know they need to save for a down payment, they often forget about closing costs. And considering how significant these costs can be, you definitely want to account for them.
Closing costs are a broad category of items that you pay at the time you buy a home. So why are they called closing costs? That’s simple: because you don’t pay them until you close on the home.
The bad news is that these expenses can add up to 2-5 percent of the sale price of the home. The good news is that this complete guide will help you prepare for closing costs. We might even find you ways to avoid — or at least reduce — them.
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What are Closing Costs?
As you’re probably aware, buying a home or any other piece of real estate is complicated. After negotiations, you’ll settle on a date to close the deal. Closing is when the previous homeowner turns the title over to you, the new homeowner.
During this exciting time, you’ll have to pay several closing costs. They might include:
- Attorney fees
- Title service fees
- Document stamps
- Document taxes
- Survey fees
- Brokerage commission fees
- Mortgage application points
- Appraisal fees
- Inspection fees
- Warranty fees, and more
Closing costs can add up quickly. This is why experts advise homeowners to save 2-5 percent of the home’s purchase price for these costs. And, yes, that is on top of what you’ve saved for a down payment.
However, you may not have to pay all — or even most — of these closing costs. It all depends on your home buying process and the type of mortgage you get. With some transactions, the seller pays some of the costs. With others, you can roll the closing costs into the mortgage.
Types of Closing Costs
Let’s talk first about the types of closing costs you might encounter and how much they tend to run. Understand that closing costs, especially tax-related costs, will vary widely depending on where you live. But we’ve estimated some costs based on national averages.
Related: How to Find the Best Mortgage Lender
Also, you should know that with fluctuations in the real estate market, closing costs also fluctuate. A 2012 US News article pointed out that closing costs had dropped pretty dramatically. Now, as the market recovers, they’re trending upward again (though not by much).
One reason closing costs dropped was because of new regulations in 2010. These government regulations were meant to shield buyers from being unprepared for their closing costs. They require lenders to provide a good faith estimate of closing costs early in the buying process. The requirement for transparency has caused the costs to decrease naturally.
Still, the national average for closing costs is over $3,000, which isn’t pocket change for your average homebuyer. So where’s all that money going? Here are some of the closing costs you might have to pay, along with average costs, based on the Allstate Home Buyers Closing Cost Worksheet.
- Mortgage Application Fee: This fee varies from lender to lender but is usually $200-$400. You don’t have to pay this fee when you’re shopping around for a mortgage. But you’ll probably pay it when your chosen lender is processing your application. Sometimes this fee is due ahead of closing.
- Appraisal Fee: Sometimes the seller will pay this fee. But it’s normally the buyer’s responsibility. Basically, the fee goes to a professional appraiser who will ensure the bank isn’t lending you more money than a property is worth. It’ll cost $100-$400.
- Building Inspection: If you need to hire a home, pest, or another specialized inspector, you’ll have to pay the fee. Some lenders will require an inspection to make sure the property is in good condition. This fee runs from $150-$400 on average.
- Survey: This is a fee you’re likely to skip, though it’s required by commercial lenders. It is for a surveyor to check out the lot and the structures on it to ensure the boundaries are properly noted. It can cost $300-$450.
- Legal Fees: Although attorney fees will add extra to your bill, you may want to pay a professional to ensure that all the documentation for your home is in order. Some lenders will bring along their own attorney, but yours will ensure that your personal interests are protected. Legal fees can run $300-$600, depending on your attorney and what you’re requiring of him or her.
- Title Search and Insurance: A title insurance company will ensure that the title to the home is free and clear — that no one else will have claims on the property. Sometimes a title search is separate from title insurance and will cost $150-$200. Title insurance varies but is usually about 1 percent of the home price.
- Private Mortgage Insurance (PMI): If you put less than 20 percent down on your home, you’ll likely have to pay PMI. The average PMI premium is 2.5 percent of the mortgage, though your premium will vary depending on the value of your home, your credit score, and your down payment. If you need PMI, you’ll likely have to pay a portion of the premium at closing.
- Homeowners Insurance: All lenders will require that you carry homeowners insurance on a property as long as it’s mortgaged. Typically, you’ll have to pay the first year’s property insurance premium in advance. Sometimes you’ll pay the insurer directly, but other times you’ll pay at closing.
- Prepaid Interest: This one can get a little complicated. Let’s say your mortgage payment is due on the 1st of every month, but you close on your new home on the 15th. If this is the case, the lender will calculate the interest you owe for those 15-16 days remaining in the month, and that interest payment will be due at closing. Sometimes the seller reimburses these costs since it’s often in his or her best interest to close as soon as possible — before your first mortgage payment is due. These costs will depend on your mortgage amount, interest rate, and the time between closing and your first payment coming due.
- Points: Points are another form of prepaid interest, but they’re generally not required. You can pay, usually, from 0-4 points on your mortgage. One point equals 1 percent of the total mortgage principal. (If you’re taking out a $100,000 loan, for instance, a point will cost $1,000.) One point usually reduces your interest rate by 1/8 percent. If you choose to pay points (rather than increasing your down payment), you’ll do so at closing.
- Escrow Fees: The majority of homeowners use an escrow system for paying real estate taxes, fire and flood insurance, homeowners insurance, and PMI. The escrow account is held either by a third party or by your lender, depending on your circumstances. It’s used to pay all of the annual or monthly premiums for these important homeownership-related items. When you close on your home, you’ll generally need to put around three months’ worth of escrow fees in the account.
- Realty Transfer Tax: The taxes you pay on transferring a property are similar to the taxes you pay when you buy a new (or new-to-you) vehicle. Taxes vary by state and municipality.
- Recording Fees: Your local government will have to record the purchase transaction of your new home, which will cost $40-$60 on average.
- Prorated Expenses: Some of the lump-sum costs associated with your home — water bills, homeowner association fees, condominium fees, etc. — could be split between you and the seller during your transaction. If you buy a home midway through the year, for instance, you may need to pay 50 percent of these fees. These expenses will depend on when you buy your home and are often negotiable with the seller.
Ways to Pay Closing Costs
There are several ways to pay closing costs. Start by getting a Good Faith Estimate, and then figure out which option will work best for you.
Good Faith Estimate
According to HUD, the Real Estate Settlement Procedures Act requires that a lender give you a “good faith estimate” of your closing costs within three business days of your submitting your loan application.
Basically, the Good Faith Estimate (GFE) is part of shopping around for a mortgage. Because different lenders have different requirements, closing costs can vary widely. So before you choose a mortgage, look over the GFE to find differences between lenders.
While federal regulations aiming for more transparency in home lending have made good faith estimates somewhat more accurate, you have to remember that it’s still an estimate.
Saving for closing costs is a “hope for the best, plan for the worst” situation. Try to figure out the most you’d have to pay in closing costs, and be prepared to pay them (while still leaving some cash in reserves). But you should also find the best lender for your needs and reduce closing costs as much as possible.
Pay in cash
The easiest way to pay closing costs, of course, is cash. If you have enough money in savings to pay for your down payment and your closing costs and to still have cash in reserve, this is often the best option.
Paying more closing costs keeps you from taking out a bigger loan and can save you money on mortgage interest. This could save you a fortune over the life of your loan.
Roll it into the mortgage
If you don’t have plenty of cash on hand, you can roll your closing costs into your mortgage. Closing costs are generally a tiny amount of money compared to your mortgage. So most lenders don’t mind rolling these costs into the loan.
However, you do have to be careful because this step may mean you can’t spend as much money on a house. For instance, if your lender agrees to finance up to 90 percent of the value of a $150,000 home, they may not go over that loan-to-value ratio, even to roll in closing costs.
In this scenario, say you’ve agreed to put $15,000 (10 percent) down on a home worth $150,000. Your lender agrees to finance 90 percent of the home’s value, leaving a $135,000 mortgage. If you don’t have cash for the $5,000 in closing costs, you could ask the lender to roll that into your loan, making your mortgage $140,000.
But if the lender isn’t comfortable financing 95 percent of the home’s value (a very high loan-to-value ratio in the world of home lending), you may be out of luck. In this case, you might have to find a cheaper home so that you can make a smaller down payment. This will leave you money in the bank to pay closing costs.
One thing to note: many government-backed loans, like the FHA and VA loans, are set up specifically for first-time or lower-income homebuyers. These are the buyers who are most likely to have trouble saving for a down payment and closing costs. Because of this, these loans often roll closing costs into the mortgage. They may even finance above 95 percent of the home’s value.
Also, remember that even adding a couple of thousand dollars to your mortgage will affect your monthly payment. And since you’ll be financing those costs, you’ll pay interest on them, too. Five or six percent interest on $2,000 might not sound like much. But over the course of a 30-year mortgage, it can really add up!
Who Pays Closing Costs?
As the buyer, you don’t always have to pay closing costs. You can negotiate to have the seller or even the lender pay for some (or all) of the closing costs.
Ask the seller to pay some costs
This is easier to accomplish in a sluggish housing market or any time the seller is ready to get out of the home ASAP. But it never hurts to ask. If the seller has good equity in the home, they can finance closing costs out of the money they’re getting for the home.
Asking the seller to pay closing costs, or part of them, is great. It doesn’t increase your mortgage or monthly payments. And what’s the worst that can happen? The seller may just say no.
Ask the lender to pay closing costs
Sometimes, a lender will pay your closing costs without even rolling them into your mortgage. For instance, your lender might just outright pay $4,000 toward your closing costs but then raise the interest rate on your loan by 0.25 percent or more. (They’re not in the habit of giving away free money, after all.)
You’ll need to make sure this doesn’t come back to bite you. Figure out how much that extra interest will cost you over the life of your loan, or at least the length of time you plan to be in the home, and see if this is a reasonable approach for you.
Borrow for your closing costs
Taking out a separate loan for a down payment is usually a no-no. Your main lender wants to be the only one to have a claim on your home if you should default.
However, you could take out an unsecured loan to cover closing costs. Just be careful here, as interest rates could really bite on a personal unsecured loan.
How Much Are Closing Costs?
This is a lot of information, I know. Unfortunately, it still doesn’t tell you exactly how much you’ll pay in closing costs.
You may not know the exact closing costs until you’re ready to close on your home, but you can get a good idea of these costs online by using these resources:
- SmartClosing Calculator – This calculator from Zillow will calculate costs based on where you’re buying a home, so taxes and government fees will be added in. The calculator will also show you the total amount you can expect to pay in mortgage payments, including real estate taxes and homeowner’s insurance.
- How do closing costs impact my interest rate? – This calculator will help you see how paying down points at closing can affect your interest rate.
- SmartAsset Closing Costs Calculator – This is another calculator for basic closing costs. Compare it to Zillow’s to get an even better idea of your potential costs.
Being prepared, saving enough extra cash to cover closing costs, and preparing for the worst can help ensure that your home buying experience goes off without a hitch.
Have you had any notable experiences with closing costs? Did you pay them outright, roll them into your mortgage, or get lucky and have your seller (or lender) pay them for you?