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So you’ve found the perfect home, have gotten pre-approved, and have a good sense of what you’ll be paying monthly. You also have a down payment set aside that you’ve saved up especially for your dream home. You’re all set, right? Well, not just yet. In addition to your down payment, closing costs are upfront expenses that you’ll want to keep in mind when approaching the home buying process – and not all mortgage companiesset the expectation for what this amount will turn out to be.
What are mortgage closing costs? Simply, they are fees charged directly by the lender and/or third parties involved in the mortgage transaction that are due at the time of closing. While sellers are sometimes required to cover a portion of closing costs, the bulk is paid by the borrower.
Mortgage closing costs can roughly be divided into five categories:
- Lender Fees
- Third-Party Fees
- Prepaid Items
- Escrow Account Funds
- Adjustments Related to Your Interest Rate
Let’s go through each category and break down what items are involved. Think of this as the ultimate guide to closing costs:
1. Lender Fees: Fees that the lender charges to process, approve and fund your loan. These fees might change slightly from lender to lender, but typically not by much. They include:
- Underwriting: Underwriting is the process by which the lender determines your loan eligibility. This fee covers the lender’s cost for underwriting your loan application.
- Government Recording: After originating your mortgage, the lender must then record the mortgage with the applicable government entity (typically the county recorder’s office) in order to protect its collateral interest in your property. This fee covers the lender’s cost of recording your mortgage.
- Origination Fee: Usually calculated as a percentage of the loan amount, ranging from 1% to 1.5%. This fee might cover some of lender’s overhead costs plus allow for profit.
2. Third-Party Fees: Fees charged by third parties in connection with the processing of your loan. These fees will typically not change (or change very little) from lender to lender.
- Appraisal: Regulation requires an appraisal to help the lender assess the true value of a property. The appraisal management company, who chooses the appraiser in accordance with regulation, charges an appraisal fee for their service. Current regulations require lenders to charge exactly what the cost of the appraisal is.
- Flood Certification: The lender needs to make sure your property is not located in a flood zone. This fee covers the cost of obtaining a report from the Federal Emergency Management Agency (FEMA) indicating whether or not your property is located in a flood zone.
- Closing/Settlement: What the title or closing agent charges for managing the closing of your loan on the closing day and making sure that your note and deed are properly filed.
- Owner’s Title Insurance: This title insurance policy protects the buyer of a property against financial loss due to title defects or liens. In many states, the property seller typically covers this cost.
- Lender’s Title Insurance: This title insurance policy protects the lender against financial loss due to title defects or liens. The borrower typically covers this cost.
- Transfer Taxes: This is a tax imposed by the government on the passing of title to property from one person to another. These taxes vary by state and municipality. The cost of transfer taxes is often split between the buyer and the seller, with buyer’s portion being significantly higher.
3. Prepaid Items: There are certain items, such as interest and homeowners insurance, that you are required to prepay at closing. These items will not change from lender to lender.
- Interest (est. 15 days): The amount of interest that accrues from the date of your loan’s funding to the end of the month when the funding occurred. For example, if your loan was funded on June 10, the prepaid interest should reflect 20 days to cover the period from June 11 to June 30. Since your first mortgage payment on September 1st will cover the interest from August; in order to be all caught up the interest from the month of closing needs to be paid upfront. It is industry best practice to use 15 days as an estimate, since the exact date of your loan closing is still unknown.
- Homeowners Insurance (Purchase transactions only): Lenders require that borrowers purchase homeowners insurance, also known as hazard insurance. The lender will require an upfront payment at closing to cover a full year’s premium of homeowners insurance, as required by the policy provider.
4. Escrow Account Funds: Lenders require an initial escrow deposit to start your escrow account. Escrow accounts (sometimes referred to as impound accounts) are set up to pay certain property-related expenses, such as property taxes and homeowners insurance. These expenses are usually paid once or twice per year, but your lender will break them down into monthly installments and add them to your mortgage payment each month.
The benefits of an escrow account include slightly lower interest rates and the convenience of having all your property-related expenses lumped into one monthly payment. The reason why you need to “load” that account with some initial funds is that there might not be enough monthly contributions to add up to a balance required to meet tax or insurance obligations. Let’s use the following scenario as an example: your taxes are due in October and are paid semi-annually. Your closing occurs in the middle of June, with a first payment due in August (remember, with mortgage payments you pay for the previous month at the beginning of each month). When October rolls around, the lender should pay half of the annual tax bill, which equals 6 monthly tax escrow payments, yet you’ve only made 3 payments so far. In this case, a lender would ask you to contribute 4 monthly tax payments at the point of loan closing, with 3 payments going towards the deficit and one acting as a buffer in case there is an increase in a tax bill. If you are refinancing and have an escrow account set up with your current lender, you will receive a reimbursement from your current lender with any unused funds available in your current escrow account. Expect a check from your current lender 2-4 weeks after closing.
- Property Taxes : This is a tax levied by the government where the property is located in order to support local education and resident services such as police and fire protection. The exact amount you’ll need to deposit into your escrow account at closing varies depending on your closing date.
- Homeowner’s Insurance : In addition to the upfront payment at closing to cover a full year’s premium of homeowners insurance (on purchase only), the lender also requires that some funds be deposited into your escrow account at closing to cover your monthly homeowners insurance.
- Mortgage Insurance : Mortgage insurance protects the lender from a potential borrower default. It is typically required by the lender when you put less than 20% down to purchase your home or, if you’re refinancing, when your Loan-to-Value if higher than 80%. The lender requires that some funds be deposited into your escrow account at closing to cover your monthly mortgage insurance. We estimate this amount at two months of your monthly mortgage insurance payment.
5. Adjustments Related to Your Interest Rate: Depending on the particular interest rate you choose, you will most likely either receive a borrower credit from the lender (which decreases your total closing costs) or be required to buy down points (which increase your total closing costs in exchange for a lower interest rate). If you are unsure which option is better suited for you, one of our mortgage guides can help you weigh the pros and cons.
- Borrower Credit: A credit that may be offered to you by the lender for choosing a particular interest rate. The higher the interest rate, the more borrower credit you will receive from the lender, thereby decreasing your total closing costs.
- Buy Down Points: An additional cost that may be added for choosing a particular interest rate. If you want to lower your interest rate even more, you will have to buy down more points, thereby increasing your total closing costs.
So how much can you expect to pay in total? The rule of thumb is to budget 2-4% of your property price for closing, but that should just be your starting point. Of course, closing costs will vary by location and property type, but the above is a good estimate of items due at closing. Unfortunately, most online mortgage companies will forego showing closing costs items such as Prepaid Items and Escrow Funds, so make sure you ask twice when you’re given a quote.