What Are Closing Costs?
Closing costs are an inescapable part of buying a home, but you can reduce those expenses.
Buyers and sellers have expenses to pay at the settlement table.(Getty Images)
While first-time homebuyers typically focus on saving money for a down payment, you also need to budget for closing costs, which are an essential expense of homebuying. Some closing costs, such as real estate agent commissions, are paid by home sellers.
The term “closing costs” includes a variety of expenses above the purchase price of your property, such as fees for an attorney, a title search, title insurance, taxes, lender costs and some upfront housing expenses such as homeowners insurance. Some of those costs are nonnegotiable, such as recording or transfer taxes charged by your state or local government. Others, such as your lender’s fee, can be negotiated. You may also be able to negotiate with the home seller or your lender to cover some of your closing costs.
The amount you’ll pay in closing costs varies according to the size of your loan and tax laws in your area. Closing costs average 2 to 5 percent of the purchase price. For example, if you’re buying a $300,000 house, the total closing costs could range from $6,000 to $15,000.
Understanding Closing Costs
By law, homebuyers must receive a loan estimate from your lender within three days of it receiving your loan application, and that includes an estimate of closing costs. Three days before your scheduled closing, you should receive your closing disclosure, a document that provides final details about your loan and your closing costs.
“There are essentially three sections of closing costs that buyers need to pay, including lender fees, title company fees and prepaid costs,” says Henry Brandt, branch manager of Planet Home Lending in Irving, Texas.
Lender fees: Some lenders wrap all their costs into an “origination” fee, and others break them out into a list of things like courier fees, appraisal costs, administrative fees, processing fees, a credit check, transfer taxes, a flood certification if one is required and underwriting fees, says Brandt.
An optional closing cost is a discount point, equal to 1 percent of the loan amount. Discount points can be used to lower your interest rate. You can consult with your lender to discuss the pros and cons of paying discount points. In general, if you’re cash-poor, you’re less likely to want to pay extra upfront to bring down your interest rate.
Title fees: About 70 percent of closing costs are title-related, says Todd Ewing, founder of Federal Title & Escrow in Washington, D.C., which is why he recommends that buyers shop for title services if they can. Those costs include a title search, title insurance and settlement services.
“Title insurance premiums don’t vary much, but the settlement fees can vary by several hundred dollars from one company to another,” says Ewing. “To compare fees, make sure you understand what’s covered, including a title search and courier fees.”
Lenders require buyers to purchase title insurance that covers the lender up to the amount loaned. Most real estate experts recommend that buyers also purchase optional owner’s title insurance to protect their own investment in the home. Both types of title insurance provide protection if someone claims they have an ownership right to your home or have not been paid for work on the property and have a lien against it. Title insurance can protect you if the previous owners failed to pay taxes on the property.
“Some people foolishly decide to opt out of owner’s title insurance to save money, but it can be costly,” says Ewing. “One buyer of a $1 million property in Washington, D.C., decided to save $2,000 and skip it, but three months later it turned out a lien on the property hadn’t been properly recorded, and he had to pay about $50,000 in attorney’s fees to straighten it out.”
Prepaid costs: Most lenders require borrowers to set up an escrow or impound account to collect homeowners insurance and property taxes, although if you make a down payment of 20 percent or more you can sometimes be exempt, says Brandt.
“At the closing, you’ll pay one year of your homeowners insurance plus two months of homeowners insurance premiums to be kept in reserve,” says Brandt. “Usually you’re also required to pay two to six months of property taxes depending on when the tax bill is due. In states with high property taxes, that can add up to thousands of dollars at the closing.”
Who Pays Closing Costs
Both buyers and sellers have expenses to pay at the settlement table, but what they pay depends on local traditions, market conditions and negotiations between buyers and sellers. Sellers typically pay the real estate agents’ commissions at the closing, but in some areas, they pay other fees, too.
Buyers pay for the majority of closing costs in most parts of the country, but there are a few jurisdictions where it’s common for the sellers to pay, says Ewing.
For example, in North Carolina, says Sam Grogan, a real estate agent with Coldwell Banker Residential Brokerage in Charlotte, sellers pay the sales tax on transactions.
“First-time buyers often don’t know about closing costs, and they’ll say, ‘My friend bought a house, and the sellers paid all of the closing costs,'” says Grogan. “We explain the process so they understand that usually means the buyers have negotiated with the sellers to finance the cost.”
Reducing Closing Costs
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. The two most common are lender-paid or seller-paid closing costs.
“Buyers get confused when we talk about seller-paid closing costs, so I think this should be called ‘buyer-financed’ closing costs,” says Grogan.
Essentially, buyers can ask sellers to allow them to raise the purchase price in exchange for a credit at the settlement table to cover closing costs.
“For example, if the seller wants $200,000 for the house and closing costs are estimated at $5,000, you can offer $205,000 and get a credit for the closing costs,” says Grogan. “The seller gets the same net profit, and the buyer finances the closing costs into the transaction.”
Grogan says this is common for properties in a lower price range, although in a competitive market some buyers try to avoid asking for closing cost help because it can make them look weak.
“In 2008 to 2010, when it was a buyer’s market, it was common across all price ranges to ask sellers to pay closing costs outright and not even raise the price to cover them,” says Grogan.
A potential problem for buyer-financed closing costs is that the home must appraise at the full purchase price, including the extra for a closing cost credit. Your real estate agent can help you assess whether you could face appraisal problems.
Buyers can also request lender-paid closing costs, which means the lender will pay the closing costs and charge a slightly higher interest rate to recoup the money, Brandt says.
“Whether it’s seller-paid or lender-paid closing costs, basically the buyer is financing those closing costs either with a higher balance or a higher mortgage rate,” says Brandt.
You can also negotiate some closing costs. However, Brandt says less than 25 percent of closing costs can be negotiated, while the rest are hard fees that can’t be changed.
“You can always try to negotiate your lender’s fee, but your success depends on your borrower profile and market conditions,” says Brandt. “If you have great credit and income and can go anywhere to get a loan, you’re more likely to be able to get your lender to lower the fee. If you are a riskier borrower, a lender is less likely to consider a lower fee. In a slow market, a lender may be more willing to make concessions in order to stay busy.”
Shopping for title services can save you a few hundred dollars, says Ewing, provided you as the buyer can choose your title company.
You may also be able to reduce your title insurance expenses.
“Title insurance companies offer enhanced title insurance that costs about 20 percent more than standard title insurance,” says Ewing. “It’s smart to compare what each policy offers and see if it’s worth it to you to pay more. Most of the extra coverage applies to recently built homes to cover things like a mechanic’s lien, so you may or may not need it.”
Another potential option is to request a “reissue rate” on your title insurance.
“You can ask the sellers in your purchase contract to ask their title insurance company if they can provide a reissue rate to the buyers rather than a new title insurance policy rate,” says Ewing. “If they’re willing, it could save as much as 40 percent of the title insurance premium.”
One more option, typically available to low- to moderate-income households, is to apply for homeowner assistance.
“The loans associated with those programs sometimes have slightly higher interest rates, but it’s a great option to get some or all of your down payment and closing costs covered so you can keep more of your cash in reserve for emergencies,” says Brandt.
Programs are available through state and local government agencies and from some employers.
Controlling Your Closing
Market conditions and local customs often dictate who picks the title company to handle the closing. In the D.C. area, for example, the buyer traditionally picks the title company, but in Texas, says Brandt, it’s often the seller’s choice.
“In a seller’s market, the seller always gets to pick the title company, but in a buyer’s market, sometimes the buyer chooses,” says Brandt. “In reality, the real estate agent usually recommends the title company, and that’s the one everyone goes with because of their relationship.”
Buyers and sellers have the right to shop for a title company and are not obligated to accept their agent’s recommendation.
In addition to choosing what company to use, you can also negotiate the settlement date, which can impact your closing costs.
“If you close at the end of the month, the lender will only charge one or two days of prepaid interest, but if you close on the first of the month, you’ll pay the full 30 days of interest,” says Ewing. “But it’s really only a cash-flow difference since your closing date also impacts the date your first mortgage payment is due.”
Why You Must Pay Closing Costs
Paying closing costs on top of your home purchase may feel excessive, but Brandt says that the fees are necessary.
“First, you always want a title search to make sure you have legal possession of your home,” he says. “And naturally lenders want to get a return on their investment for loaning you hundreds of thousands of dollars. The third part, your escrow account, is actually a good way to protect yourself from neglecting to set aside several thousand dollars for taxes and insurance. It’s much easier to pay $250 or $300 every month than to come up with $4,000 once a year.”
Brandt estimates that about 25 percent of the loans his company handles have some form of closing cost assistance, either from the sellers or the lender or a homeowner assistance program.
Grogan says, “The lack of cash for closing costs should not be an obstacle to homeownership.”
A combination of negotiations, comparing fees and possibly financing your closing costs with the help of your sellers or lender should make your closing costs easier to handle.
Buying a home can be nerve-racking, especially if you’re a first-time home buyer.
These tips will help you navigate the process, save money and avoid common mistakes. We organized them into four categories:
Mortgage down payment tips.
Mortgage application tips.
House shopping tips.
First-time home buyer mistakes to avoid.
Mortgage down payment tips
1. Start saving for a down payment early
It’s common to put 20% down, but many lenders now permit much less, and first-time home buyer programs allow as little as 3% down. But putting down less than 20% may mean higher costs and paying for mortgage insurance, and even a small down payment can still be hefty. For example, a 5% down payment on a $200,000 home is $10,000.
Play around with this down payment calculator to help you land on a goal amount. Some tips for saving for a down payment include setting aside tax refunds and work bonuses, setting up an automatic savings plan and using an app to track your progress.
2. Explore your down payment and mortgage options
There are lots of mortgage options out there, each with its own combination of pros and cons. If you’re struggling to come up with a down payment, check out these loans:
Conventional mortgages They conform to standards set by the government-sponsored entities Fannie Mae and Freddie Mac, and require as little as 3% down.
FHA loans Loans insured by the Federal Housing Administration permit down payments as low as 3.5%.
VA loans Loans guaranteed by the Department of Veterans Affairs sometimes require no down payment at all.
Making a higher down payment will mean having a lower monthly mortgage payment.
If you want the smallest mortgage payment possible, opt for a 30-year fixed mortgage. But if you can afford larger monthly payments, you can get a lower interest rate with a 20-year or 15-year fixed loan. Use our calculator to determine whether a 15-year or 30-year fixed mortgage is a better fit for you. Or you may prefer an adjustable-rate mortgage, which is riskier but guarantees a low interest rate for the first few years of your mortgage.
3. Research state and local assistance programs
In addition to federal programs, many states offer assistance programs for first-time home buyers with perks such as down payment assistance, closing cost assistance, tax credits and discounted interest rates. Your county or municipality may also have first-time home buyer programs.
Mortgage application tips
4. Determine how much home you can afford
Before you start looking for your dream home, you need to know what’s actually within your price range. Use this home affordability calculator to determine how much you can safely afford to spend.
5. Check your credit and pause any new activity
When applying for a mortgage loan, your credit will be one of the key factors in whether you’re approved, and it will help determine your interest rate and possibly the loan terms.
So check your credit before you begin the homebuying process. Dispute any errors that could be dragging down your credit score and look for opportunities to improve your credit, such as making a dent in any outstanding debts.
To keep your score from dipping after you apply for a mortgage, avoid opening any new credit accounts, like a credit card or auto loan, until your home loan closes.
6. Compare mortgage rates
Many home buyers get a rate quote from only one lender, but this often leaves money on the table. Comparing mortgage rates from at least three lenders can save you more than $3,500 over the first five years of your loan, according to the Consumer Financial Protection Bureau. Get at least three quotes and compare both rates and fees.
As you’re comparing quotes, ask whether any of the lenders would allow you to buy discount points, which means you’d prepay interest up front to secure a lower interest rate on your loan. How long you plan to stay in the home and whether you have money on-hand to purchase the points are two key factors in determining whether buying points makes sense. You can use this calculator to decide whether it makes sense to buy points.
7. Get a preapproval letter
You can get pre-qualified for a mortgage, which simply gives you an estimate of how much a lender may be willing to lend based on your income and debts. But as you get closer to buying a home, it’s smart to get a preapproval, where the lender thoroughly examines your finances and confirms in writing how much it’s willing to lend you, and under what terms. Having a preapproval letter in hand makes you look much more serious to a seller and can give you an upper hand over buyers who haven’t taken this step.
House shopping tips
8. Hire the right buyer’s agent
You’ll be working closely with your real estate agent, so it’s essential that you find someone you get along with well. The right buyer’s agent should be highly skilled, motivated and knowledgeable about the area.
9. Pick the right type of house and neighborhood
You may assume you’ll buy a single-family home, and that could be ideal if you want a big yard or a lot of room. But if you’re willing to sacrifice space for less maintenance and extra amenities, and you don’t mind paying a homeowners association fee, a condo or townhouse could be a better fit.
But even if the home is right, the neighborhood could be all wrong. So be sure to:
Research nearby schools, even if you don’t have kids, since they affect home value.
Look at local safety and crime statistics.
Map the nearest hospital, pharmacy, grocery store and other amenities you’ll use.
Drive through the neighborhood on various days and at different times to check out traffic, noise and activity levels.
10. Stick to your budget
Look at properties that cost less than the amount you were approved for. Although you can technically afford your preapproval amount, it’s the ceiling — and it doesn’t account for other monthly expenses or problems like a broken dishwasher that arise during homeownership, especially right after you buy. Shopping with a firm budget in mind will also help when it comes time to make an offer.
In a competitive real estate market with limited inventory, it’s likely you’ll bid on houses that get multiple offers. When you find a home you love, it’s tempting to make a high-priced offer that’s sure to win. But don’t let your emotions take over. Shopping below your preapproval amount creates some wiggle room for bidding. Stick to your budget to avoid a mortgage payment you can’t afford.
11. Make the most of open houses
When you’re touring homes during open houses, pay close attention to the home’s overall condition, and be aware of any smells, stains or items in disrepair. Ask a lot of questions about the home, such as when it was built, when items were last replaced and how old key systems like the air conditioning and the heating are.
If other potential buyers are viewing the home at the same time as you, don’t hesitate to schedule a second or third visit to get a closer look and ask questions privately.
First-time home buyer mistakes to avoid
With so much to think about, it’s unsurprising that some first-time home buyers make mistakes they later regret. Here are a few of the most common pitfalls, along with tips to help you avoid a similar fate.
12. Not budgeting for closing costs
In addition to saving for a down payment, you’ll need to budget for the money required to close your mortgage, which can be significant. Closing costs generally run between 2% and 5% of your loan amount. You can shop around and compare prices for certain closing expenses, such as homeowners insurance, home inspections and title searches. You can also defray costs by asking the seller to pay for a portion of your closing costs or negotiating your real estate agent’s commission. Calculate your expected closing costs to help you set your budget.
13. Not saving enough for after move-in expenses
Once you’ve saved for your down payment and budgeted for closing costs, you should also set aside a buffer to pay for what will go inside the house. This includes furnishings, appliances, rugs, updated fixtures, new paint and any improvements you may want to make after moving in.
14. Buying a home for today instead of tomorrow
It’s easy to look at properties that meet your current needs. But if you plan to start or expand your family, it may be preferable to buy a larger home now that you can grow into. Consider your future needs and wants and whether the home you’re considering will suit them.
15. Passing up the chance to negotiate
A lot can be up for negotiation in the homebuying process, which can result in major savings. Are there any major repairs you can get the seller to cover, either by fully handling them or by giving you a credit adjustment at closing? Is the seller willing to pay for any of the closing costs? If you’re in a buyer’s market, you may find the seller will bargain with you to get the house off the market.
16. Not knowing the limits of a home inspection
After your offer is accepted, you’ll pay for a home inspection to examine the property’s condition inside and out, but the results will only tell you so much.
Not all inspections test for things like radon, mold or pests, so be sure you know what’s included.
Make sure the inspector can access every part of the home, such as the roof and any crawl spaces.
Attend the inspection and pay close attention.
Don’t be afraid to ask your inspector to take a look — or a closer look — at something. And ask questions. No inspector will answer the question, “Should I buy this house?” so you’ll have to make this decision after reviewing the reports and seeing what the seller is willing to fix.
17. Not buying adequate homeowners insurance
Before you close on your new house, your lender will require you to buy homeowners insurance. Shop around and compare insurance rates to find the best price. Look closely at what’s covered in the policies; going with a less-expensive policy usually means fewer protections and more out-of-pocket expenses if you file a claim. Also, flood damage isn’t covered by homeowners insurance, so if your new home is in a flood-prone area, you may need to buy separate flood insurance.