Home Buying Basics: What are closing costs?

When you purchase a new home, there are costs associated with buying that go beyond just the down payment. These costs can be similar for refinances and they are commonly referred to as closing costs. The term closing costs generally refers to all the costs associated with closing a home purchase or refinance. A more accurate term to reflect these costs is settlement costs. Settlement costs include 4 categories; lender fees, third party fees, prepaid items and taxes/government fees. Let's discuss each of these categories separately.

Lender Fees  (fees charged directly by the lender)

Origination Fee

In order to process a mortgage application, lenders may charge a flat upfront fee, or a percentage of the mortgage loan. This is referred to as the Origination Fee. Some lenders may not charge an origination fee. Origination fees are paid at the time of closing.

Points

In order to lower your interest rate, you might want to consider paying points. One point is equal to 1% of the loan amount and is payable at closing. On a refinance, some lenders will let you finance the points which means they will be added to the mortgage cost and be part of the amount borrowed. Many times on a purchase, the points may be tax-deductible in the year in which they are paid (please consult a tax professional for more information).

Application Fee

Some lenders charge a fee at the time of application in order to prepare the documentation for the next step in the process. This may or may not include the deposit for the credit report fee and appraisal fee (discussed in Third Party Fees below). The application fee is typically due at the time of application and may be non-refundable. It is best to confirm the details of any application fee and what, if anything, it will be applied to before paying it.

Underwriting/Processing Fee

Some lenders charge a fee at the time of closing for the underwriting or processing of your loan. These fees typically cover the administrative costs of approving the loan. Some lenders will simply add these fees to the origination fee as a lump sum total.

Flood Certification Fee

Lenders will verify whether or not the property is in a flood zone. This fee is typically nominal and is charged at the time of close

Transfer taxes - Required by some localities to transfer the title and deed from the seller to you.

Deed stamps - Some municipalities charge deed stamps to transfer title. This is basically another way to say transfer taxes.

Other state and local fees - Some local and state agencies may have fees beyond those listed above.

Third Party Fees (fees charged by companies other than the lender)

Document Preparation Fees

During the mortgage closing process, there are several documents and papers that must be prepared and you will occasionally see fees for this. These fees are typically paid at close.

Title Insurance

There are two forms of title insurance, an owner's policy and a lender's policy. They both provide the same protection, but the insurance benefits different parties. Title insurance is issued after a thorough investigation is done into the chain of title. It covers legal fees and any losses in the event that someone files a successful claim against the ownership rights to the property. In other words, it protects the owner or lender in case the home was not legally the property of the person it was purchased from. Owner's policies are optional and remain in effect for the time the buyer or their heirs own the property. Lender's policies are required by the lender to protect their investment and are good only for the life of the loan, hence the reason new policies are required on refinances as well. Both premiums are paid at closing.

Appraisal fees

Most lenders require that an appraisal be performed as a condition of the loan. This is to verify the selling price of the property for which the mortgage loan is issued is equal to or less than the fair market value of the property and that their investment is protected. The appraisal fee is usually paid by the buyer and is almost always paid upfront. The lender may require a deposit for this fee at the time of application, which is then held in escrow and given to the appraiser when work is completed.

Credit Report

Lenders will pull a credit report as part of the qualification process. This fee may be charged upfront around the time of application or at the time of closing. Some lenders will include the credit report fee in the application fee they charge upfront.

Inspection Fees

Some lenders require inspections (such as termite inspection) to make sure that the property is in excellent condition. In many rural areas a water test may be required to ensure the well and water system will maintain an adequate water supply to the house. This is necessary to assure that the property will retain the required collateral value to secure the mortgage loan.

In addition to inspections required by the lender, you may make the purchase offer contingent on satisfactory completion of some other inspections. These inspections might include: structural, water quality tests and radon tests. Inspection fees are typically paid at the time of inspection.

Survey

Lenders may require that the property be surveyed to verify it has not been encroached and to confirm lot size and dimensions. This fee is typically paid before the time of closing.

Prepaid Items:

Prepaid Interest

Prepaid interest is exactly what it sounds like, interest that is paid in advance. Mortgage payments are paid in arrears, meaning that you pay the interest in the month after you use the money (i.e. February's interest payment pays January's interest). Since it isn't practical for you to make a partial monthly payment only days after you purchase or refinance your home, the lender will charge a small prorated interest payment at closing. This is why most loans are not due until the 2nd 1st of the month after closing (note, this is not always the case). Prepaid interest is figured by simply multiplying the interest rate by the loan amount, dividing by 365 days, and then multiplying by the number of days left in the month when the loan closes. This is paid at the time of closing.

Homeowner's Insurance

Homeowner's insurance, also called hazard insurance, is required to be paid in advance. On a purchase, you will pay one year's premium upfront at the time of closing. If you have chosen to escrow your insurance with your lender, you will also be required to set up a cushion for that escrow account, usually two month's worth of the annual premium. The cushion is there in case the premium rises and also to cover the month you may be skipping a mortgage payment. On a refinance, you will be required to escrow a certain amount of your premium depending on when the next payment is due. These monies are collected at the closing.

Property Taxes

Property taxes up until the time of closing are almost always the responsibility of the seller. As such, the seller must cover a prorated portion of the next tax bill due. This is shown as a credit at the closing from the seller to the buyer. However, a new home owner who is escrowing their property taxes will need to set up a new escrow account with enough to cover the next property tax bill. This account will typically be funded with the seller's credit, plus a two month cushion from the buyer. Much like the homeowner's insurance cushion, this is to cover the one month that the buyer may be skipping a mortgage payment plus a little extra to cover rising property taxes or any underage.

Taxes & Government Fees (fees to paid to local or state agencies)

Recording Fees

These fees may be paid by either party and are charged by a governmental entity for entering an official record of the change of ownership of the property. The fee is required by the government for recording the deed and is charged at closing.

Statutory Closing Costs

Statutory closing costs are expenses you would have to pay to state and local agencies even if you paid cash for the house and did not need to take out a mortgage. They include the following:

This list covers many of the common fees. Each transaction can be different and special circumstances may require additional fees. It is also important to note that on a purchase, most of these fees can be negotiated into the contract for the seller to pay. It is not uncommon for a seller to issue a closing cost credit for either a specific item or just a general lump sum. Talk to your real estate agent for more information regarding seller paid closing costs. Also, on a refinance, you may be able to choose a loan option in which the lender pays many of the fees listed above, although you will have to pay a higher interest rate than if you paid them yourself. Please consult a reputable local loan officer for more information on these fees.