What You Need to Know About Closing Costs

What Are Closing Costs?

Closing costs typically range from 2% to 5% of a home's purchase price and are customarily paid upfront on the day a home purchase and the financing that enables it are finalized. They include several categories of charges, such as those below.

Fees Paid to the Mortgage Lender

Origination fees are charged by the lender as part of the cost of issuing your mortgage loan. These are commonly expressed as "points," with each point denoting 1% of the purchase price. The sizes of these fees vary, but they're generally about 0.5% to 1.5% of the loan amount.

Discount fees, also expressed in terms of points, are optional payments you can make at closing in exchange for reductions in the interest rate charged on your mortgage. Pricing can vary by lender and loan term, but paying one point (1% of the purchase price) at closing might lower the interest rate on your loan by 0.25%. On a typical 30-year mortgage, even small interest rate reductions can save you thousands of dollars over the life of the loan.

You should discuss the discount options available on your loan with your lender, and determine if you want to pay them, and how much they cost, well before closing, so that the documents you sign at closing reflect those terms.

You'll generally have to pay for mortgage insurance if you make a down payment of less than 20% of your home's purchase price. For conventional loans, the lender will likely require you to buy private mortgage insurance (PMI) to protect them against financial loss in case you fail to repay the loan. A loan through the Federal Housing Authority may similarly require a mortgage insurance premium.

Payments to Third-Party Service Providers

A typical home sale requires the services of multiple professionals, and fees for their services are often paid at closing.

These can include:

• Home inspection fee: A home inspector is paid to identify material defects or structural issues that affect the property's sale price.
• Appraisal fee: Lenders typically require an appraiser of their choosing to determine the home's fair market value. This is done via a property inspection and a review of the prices at which comparable homes in the area sold for.
• Title search services: A title search verifies the seller's legal right to transfer the property to the buyer and flags any liens that may have to be cleared before the sale can be completed.
• Title insurance premiums: Sellers are typically required to buy an insurance policy (at a typical cost of around $1,000), to protect the lender against any court or administrative costs that arise if liens or other claims on the property are uncovered in the title search. Sellers also have the option of buying title insurance to cover their own expenses in case legal action is required to clear the title for sale.
• Real estate attorney's fees: It's customary and advisable (and mandatory, in some jurisdictions) for both buyer and seller to hire attorneys to review sales contracts before a home sale is completed. In more complicated sales—if a home is occupied by tenants at the time of the sale, for instance, or if the sale is contingent on the seller completing certain repairs or improvements—attorneys may play a more active role, crafting contract provisions to protect their clients' interests.
• Agents' sales commission: Real estate agents representing the buyer and seller typically split a commission of 5% to 6% of the sales price.

Escrow Accounts

Along with the amount you owe on your mortgage, lenders typically collect 1/12 of your annual property tax bill and 1/12 of your homeowners insurance policy premium in each monthly bill. Funds the lender collects to pay taxes and insurance are placed in a special savings account known as an escrow account, from which the lender (or mortgage servicer) pays taxes and insurance bills on your behalf. Under federal law, the lender may require you to place your first year's tax and insurance payments in escrow at closing, along with up to two months' mortgage payments (including PMI premiums, if applicable), to give the lender leeway in case you are late on monthly payments.

The amount of the escrow payments required at closing can vary widely, depending on local property tax and insurance rates. If you're buying a home in an area prone to natural disasters such as floods, earthquakes or tornadoes, your lender may require special insurance coverage against those events as well, and the first year's premiums for them also would be placed in escrow.

Anticipating Total Closing Costs

When thinking about a home purchase, it's easy to get focused on the amount of the down payment you'll be able to put down on your house, and how much money you'll be able to borrow based on that down payment. It's important to remember that you'll need to write a check for more than just the down payment on the day you finalize the sale, and to make sure you've allocated funds accordingly.

Here are some ways to anticipate how much you'll need at closing:

• Study loan estimates. When you're ready to bid on a house, it's wise to apply for mortgages from multiple lenders, compare lending terms and look for the best deal you can get. Within three days of receiving your application, each lender that approves your application must send you a standardized loan estimate document, which includes a section that details anticipated closing costs, including estimated taxes and lender fees. You can use these to get a good idea how much you'll need in addition to your down payment on closing day.
• Study the closing disclosure. Once you accept a mortgage loan offer and get final approval to close on the home, the lender will issue a closing disclosure document at least 72 hours before closing that nails down the projected closing costs listed in the loan estimate. It's common for there to be some discrepancy between a lender's loan estimate and their final closing disclosure, so it's important to compare the two documents carefully to see what may have changed, and how it affects your total closing costs. If you're unsatisfied with any changes, you can cancel the loan (and the sale) at any time before closing.

Who Pays Closing Costs?

Most closing costs listed above are typically paid by the homebuyer, except for the following:

• Transfer tax: This fee, charged by many communities, is required to enable a property owner to assign ownership to someone else.
• Real estate sales commission: Real estate agents representing the buyer and the seller typically split a commission of about 6% of the purchase price, which is paid from the seller's proceeds from the sale. (The commission is taken from money the buyer pays the seller after the sale is completed, so the commission can be considered part of the price of the home.)

Closing costs traditionally paid by the buyer include:

• Home inspection fee
• Appraisal fee
• Title search fee
• Attorney's fees for the lawyer representing them in the sale

Are Closing Costs Negotiable?

The cost of taxes is determined by local regulations, but many other closing costs are negotiable. By working with the lender, seller and real estate agents, you may be able to make some cost adjustments that save you money.

You may be able to persuade a highly motivated seller to pay some closing costs the buyer traditionally covers, such as appraisal and home inspection fees and even some lender fees, such as origination points. The seller can also negotiate the amount of their commission with their real estate agent, or select an agent based on their willingness to work for reduced commission.

Note that flexibility on these matters may depend on market conditions. Lenders and sellers will likely be more inclined to grant concessions if the sales climate is sluggish, the property has been listed for sale for an extended period or there are no other serious purchase offers under consideration. Negotiating fees and interest rates is more challenging in highly competitive real estate markets such as those seen in the U.S. in the past few years.

Attorneys and real estate agents can advise you on where your best opportunities are for negotiating better terms. They should work with the lender and the seller's representatives to hammer out the details. The loan contract and purchase agreement prepared for closing should reflect final terms; closing day isn't the time for negotiation.

How Can I Reduce Closing Costs?

It's impossible to avoid all closing costs—taxes are inevitable, for example—but there are several approaches you can take to reduce the amount of the check you'll have to write on closing day.

• Hire your own professionals. Real estate agents and lenders typically work with short lists of professionals such as appraisers, title-search providers and home inspectors—and these preferred vendors may be more expensive than others you can hire yourself. If you're willing to do the legwork to find lower-cost services, you may be able to save some money by hiring some of them yourself. If you go that route, be sure to carefully vet anyone you hire.
• Ask about loyalty incentives. The bank or credit union where you have your checking or savings accounts may offer rebates or other incentives to existing customers who apply for mortgages with them. These insider loyalty incentives may only save you a few hundred dollars on closing day, so they're only worthwhile if the loan offer is otherwise competitive with other lenders you've applied to, but every little bit helps on closing day.
• Consider no-closing-cost loans. If you're seeking a new mortgage or want to refinance your existing home loan, you'll likely hear about mortgages and refinancing deals that come with no closing costs. These arrangements won't cover taxes, but they can greatly reduce the size of the check you'll have to write at closing. Note that they'll usually make you pay in other ways—by accepting a higher interest rate than you'd get if you paid fees upfront, or by "crediting" the fees by adding them to the amount of your and spreading the payments (and applicable interest charges) out over the life of the loan.

What if I Can't Afford Closing Costs?

There are programs available to help homebuyers who are having a hard time affording closing costs:

• See if your employer can help. Some employers offer down payment assistance for workers purchasing homes. Covering part of your down payment could free up cash to help pay closing costs. Check with your employer's human resources department to find out if such a program exists, and how to qualify for it.
• Investigate homebuyer assistance options. Many communities offer grants and other forms of financial help that can offset closing costs for homebuyers in their communities. Some programs are available to individuals with incomes that fall below set thresholds, others are extended to members of certain professions (teachers, first responders and the like), and still others are designed to encourage homeownership in specific towns or neighborhoods. Your real estate professional should be able to steer you toward applicable programs, and the U.S. Department of Housing and Urban Development (HUD) maintains a helpful resource for finding homebuying assistance programs in every state.
• Seek help from loved ones. Consider asking a family member or friend to lend or give you some cash you can use to cover the closing costs.
• Reduce the down payment. If your lender is willing to accept a lower down payment on the loan, it could allow you to put more cash toward closing costs. If the lender agrees, be aware that this will cost you more money in the long run: You can expect an increase on the interest rate charged. Additionally, if your down payment drops below 20% of the purchase price, you can also expect the lender to require mortgage insurance.

Are Closing Costs Tax Deductible?

Several types of closing costs are deductible from your federal income taxes for the year in which you close on the purchase. If the home is your primary residence, potential deductions include:

• Property taxes up to $10,000 (for couples filing jointly; $5,000 each if filing separately) are deductible from your federal income taxes for the year the property taxes are paid. (If you make a property tax prepayment at a closing this year for a bill that isn't due until next year, you must wait until next year to take the deduction.)
• Interest paid on up to $750,000 of the loan principal is deductible from federal income taxes in the year the payments are made.
• Discount points you pay to lower your mortgage interest rate are considered prepaid interest and are therefore tax-deductible.
• Mortgage origination fees, even if they are paid by the seller, also are deductible from your federal income tax.
• Mortgage insurance premiums are currently tax-deductible (but haven't always been and may not be in the future; check with your tax professional to be sure how to proceed).

The Bottom Line

Closing costs are largely a function of your borrowing power, and credit reports and credit scores based on them are important yardsticks lenders use to gauge your creditworthiness. Before you start shopping for a home, it's wise to take stock of your credit report, check your credit score and, if appropriate, take steps to get your credit in the best possible shape before applying for mortgage loans. Careful planning today can help make closing day one to celebrate.