Closing costs are the expenses that come with obtaining a mortgage. Closing costs can range from 2% to 6% of the total loan amount, depending on the type of mortgage and the lender.
Many homebuyers don’t realize the importance of understanding closing costs when obtaining a mortgage. In this blog, we’ll explore why closing costs are a part of a mortgage and why they’re essential to understand.
What are Closing Costs?
Closing costs are the fees that are incurred at the closing of a mortgage loan. They include fees such as appraisal fees, credit report fees, title search and insurance fees, attorney fees, and other fees associated with the mortgage process.
Closing costs are typically paid by the homebuyer, with some exceptions, and they can add up to a significant expense.
Why are Closing Costs Important?
Closing costs are a part of the mortgage process for several reasons.
First, they cover the expenses associated with obtaining a mortgage, such as processing the loan application and verifying the property’s title.
Second, they protect the homebuyer by ensuring that all necessary inspections and title searches are completed before finalizing the transaction.
For example, a title search can uncover any issues with the property’s title, such as liens or outstanding debts, which could affect ownership of the property.
Closing costs also protect the lender by ensuring that all necessary verifications are completed and that the loan is properly secured.
Understanding Your Closing Costs
It’s essential to understand your closing costs when obtaining a mortgage. Your lender is required to provide you with a Loan Estimate within three days of receiving your mortgage application.
The Loan Estimate will provide you with an estimate of the closing costs associated with your mortgage. This estimate will give you a general idea of the expenses associated with obtaining the loan and the amount of money you’ll need to bring to closing.
What is Included in Closing Costs
Some lenders charge an application fee to process your loan request. This fee varies by lender but can be up to $500, or more in some cases.
This may be a separate fee or used as a deposit to be used toward other closing costs later. Your application fee is typically nonrefundable, even if you’re rejected for a loan.
The appraisal fee is the cost of having the property appraised to determine its fair market value.
The appraisal is necessary for the lender to verify that the property’s value is sufficient for the loan. This fee is usually paid by the borrower and can range from $400 to $800.
The appraisal is conducted by a licensed appraiser who visits the property and conducts a thorough inspection of its condition, size, and location.
The appraiser then prepares a report that includes the value of the property based on the appraiser’s professional opinion.
While the borrower pays for the appraisal, the lender typically hires the appraiser through a third-party Appraisal Management Company (AMC).
In some states, an attorney is required to close a mortgage loan. This fee covers the services of a real estate attorney who reviews and coordinates the closing of the transactions and transfer of property title.
Your closing fee goes to the escrow company or closing agent who conducts your closing. The fee differs based on the state you’re in and whether the presence of a lawyer is mandatory at the time of your closing.
The average cost is 1% – 2% of the purchase price of the home. Though most closing agents charge fees in line with industry standards, you can ask to negotiate this fee.
Closing/Escrow Processing Fee
In addition to the closing/escrow fees above, some closing agents may charge an additional flat fee, sometimes called a processing fee. This fee can vary depending on the type of transaction and purchase price. This fee can also be negotiated with the closing agent.
Courier and messenger fees cover the cost of transporting mortgage documents by closing agent and title company.
Both the escrow/closing agent and the title company may charge this fee. Expect to pay around $30 to $150 in courier fees.
Credit Report Fee
The credit report fee covers the cost of obtaining the borrower’s credit report. This fee can range from $25 to $50 per borrower and is usually paid by the borrower.
An escrow account, also known as an impound account, is a reserve account created by the lender when you opt to include property taxes and insurance payments in your monthly mortgage payment.
If you choose to do so, the lender will calculate the total annual amount due for taxes and insurance, divide it by 12, and add the resulting figure to your monthly payment. In return, they will make payments when they become due.
However, at closing, your lender will require you to put a certain number of months’ worth of property taxes and insurance expenses into this escrow account.
The number of months required for property tax reserves depends on your lender and the number of months between your first mortgage payment date and the next installment due date. The closer your first payment date is to the next installment date, the higher the number of months needed for the initial reserves.
The homeowner’s insurance is typically paid in full for the first year at closing and lender will require 2 – 3 months of reserves.
The required reserves can increase your total closing costs by a significant amount.
It’s worth mentioning that although creating an escrow/impound account doesn’t provide savings on property taxes and insurance costs, most lenders give pricing incentives, either in rate or lender fees/credits, to their clients to create this account. This is because it protects them against future defaults by the borrower.
Be sure to ask your lender or loan officer if they offer pricing incentives if you opt for an impound account.
FHA Upfront Mortgage Insurance Premium (MIP)
The upfront mortgage insurance premium (MIP) is a fee required for FHA loans and covers the cost of insuring the loan in case of default. The current MIP rate is 1.75% of your base loan amount.
For example, if you borrow $400,000 to buy your home, your MIP due at closing is $7,000. This upfront payment is separate from your monthly MIP, which ranges from 0.15% to 0.75% of your loan value.
Most lenders will allow this fee to be added to the loan amount, which can be a huge out of pocket saving on your closing costs.
If your home is on or near a flood plain, you may need to pay $15 – $25 for a flood certification. This money goes to the Federal Emergency Management Agency, which uses the data to plan ahead for emergencies and to target high-risk zones.
This closing cost only applies if you’re buying a house in a flood zone.
If the flood certification does indicate that the property is in a flood zone, you will be required by the lender to purchase flood insurance in addition to the hazard insurance.
If you’re purchasing a condo, townhome, or a property that is part of a homeowner’s association (HOA), your lender will most likely require a questionnaire (also referred to as condo questionnaire).
This is a form that the HOA completes, answering specific questions that the lender reviews to ensure there are no pending issues with the property and HOA, such as safety issues and pending lawsuits.
The cost of this questionnaire depends on the HOA or managing entity and is not a fee collected by the lender in most cases.
Homeowners Association Transfer Fee
Your homeowner’s association transfer fee covers the cost of moving the burden of HOA fees from the seller to the buyer. It ensures that the seller is up to date on their HOA dues.
It also provides you with a copy of the association’s payment and due schedule as well as their financials.
Usually, the seller covers this fee. However, in a highly competitive market or if you agree to cover all the closing costs, you may be required to pay for the transfer fee yourself.
The amount you’ll pay for your transfer fee is set by the HOA or managing entity, and usually non-negotiable. If the property is not part of an HOA, you won’t pay this fee.
Homeowners insurance, which includes hazard insurance, provides compensation if your home is damaged by fire or other natural disasters.
Most mortgage lenders require you to have a minimum amount of coverage as a condition of your loan to cover damage and protect their interest. This is typically the lower of either the loan amount or the cost to replace the home.
In addition to protection for your home, you have the option to obtain coverage for the contents within your home and liability coverage in case someone is injured on your property.
A home warranty, also known as a home buyer’s warranty, provides the buyer with protection against the failure of a home’s appliances and important systems, such as HVAC and plumbing.
This is usually negotiated to be paid by the seller for the first year at closing.
Mortgage Discount Points
Some lenders provide borrowers with the opportunity to lower their interest rate by prepaying a part of the interest that is owed throughout the loan’s duration.
This process is referred to as “buying down” the rate or paying “discount points”. For every 1% of interest that borrowers prepay at closing, they can usually lower the interest rate for the term of their loan by about .25% -.5%.
But paying discounts points may not always be a good idea.
The origination fee is the fee charged by the lender for processing the mortgage application. This fee is typically a percentage of the loan amount and can range from 0.125% to 2%.
For example, if you’re taking out a $400,000 mortgage, the origination fee could be between $500 and $8,000.
The origination fee covers the cost of underwriting the loan, including the verification of the borrower’s income, credit history, and assets. It also covers the cost of processing the loan application, including paperwork, credit reports, and other administrative expenses.
While this fee is typically non-negotiable, it’s important to ask the lender about it and compare it to other lenders’ fees to make sure you’re getting a fair deal.
Prepaid Daily Interest Charges
Your lender may require you to make an initial payment for the interest that accrues on your loan from the date of closing/funding to your first mortgage payment date. This amount will depend on your loan amount, interest rate, and closing date.
Keep in mind that this is not an additional expense for a service, it’s a prorated amount of your mortgage interest.
For example, if your loan closes on March 15, your first payment to the new lender will not be due until May 1st (lenders usually cannot request a mortgage payment sooner than 30 days from closing). And since mortgage payments are typically paid in arrears, the May 1st payment will cover the interest for the month of April.
In this example, you would prepay the interest from March 15 to March 31st at closing.
Prorated Real Estate Taxes
When you purchase a property, you’re required to pay the real estate taxes for the portion of the year for which you took over ownership of the property.
If the seller has paid property taxes up to a date passed the closing date, you would be paying a prorated amount (a credit to seller at closing) that covers the time period between closing and the paid through period.
For example, if you close escrow on December 15 and the seller has paid the property taxes through February of the following year, you would be paying prorated taxes covering from December 15 through the following February.
When you buy real estate, a new deed showing your ownership must be filed with the local county recorder’s office. This document shows the new ownership of the property, and counties typically charge a nominal fee for filing the new deed.
Sub Escrow Fee
Sub-escrow is a service provided by your Title Company to ensure any liens against the property are paid in full, so a title policy can be issued as required.
The sub-escrow fee is a rate that is filed with the California Department of Insurance and is generally a charge to reimburse the title company for the processing the sub-escrow.
In some states, you must get a land survey before you can complete a home sale. A survey fee goes to the survey company that verifies and confirms your property lines before you close.
In some cases, the lender will hire a third-party company to verify that your calculated property taxes are correct. This company will also notify your lender if you miss any ongoing property taxes in the future (this is why lenders give incentive for escrow/impound accounts).
The cost of this fee will depend on where you live, and the service provider selected by your lender.
Lender’s Title Insurance Policy
Title insurance policy protects the lender and the borrower against losses related to any defects in the title. The policy includes searching public records to verify the property’s title to ensure that there are no liens or other issues that could affect ownership (title) of the property.
If there is a lien on the property that was not discovered during the title search from the previous owner, title insurance would cover the cost of removing the lien.
An example would be that a seller previously hired a contractor to do work on the property but never paid the contract. And the contractor has filed a lien against the property for monies owed to them.
If the lien is discovered against the property after the buyer takes ownership, then the title insurance would cover the cost associated with satisfying and removing the lien.
The title search and insurance are typically conducted by a title company, which is responsible for ensuring that title is clear before transferring ownership of the property to the borrower.
The fee will depend on your loan amount and the location of the property, but you can estimate the fee to be around .15% – .25% of your loan amount.
Note that a Lender’s Title Insurance Policy and an Owner’s Title Policy are two separate policies, and seller usually pays for the Owner’s Title Policy. If the buyer is a cash buyer, then there is no need for a Lender’s Title policy since there is no lender.
If you finance a home using a VA loan, you will generally pay a VA funding fee at closing. The fee covers administrative costs for the VA loan program and is based on several factors such as down payment amount, transaction type (refinance or purchase), and whether it’s your first time or subsequent use of VA benefits.
Currently, for first-time VA users who put down less than 5% on their loan, the VA funding fee equals 2.3% of the total loan value, or 3.6% for subsequent uses. A 5% down payment reduces the fee to 1.65%, and a 10% down payment reduces it to 1.4%. The last two percentages are the same, regardless of whether it’s your first or 10th time.
For a refinance transaction from a different loan type into a VA loan, the funding fee is 2.3% for the first use and 3.6% for subsequent uses. However, VA Streamlines (also known as IRRRLs or Interest Rate Reduction Refinance Loans) have a 0.5% funding fee.
You may qualify for a waiver of the funding fee if you are receiving VA disability benefits or are applying as a surviving spouse of a veteran who died while in service or because of a service-related disability. Purple Heart recipients serving in an active-duty capacity are also exempt from the funding fee.
Ways to Reduce Closing Costs
There are several ways to reduce your closing costs when obtaining a mortgage. One way is to negotiate with your lender and other vendors that you have control over hiring. You may be able to negotiate some fees, such as the origination or application fee, to decrease your closing costs.
Another way to lower your closing costs is to shop around for the best deal. Different lenders may offer various fees and rates, so it’s essential to compare the costs and terms of various lenders before making a decision.
On refinance transactions, you may also be able to roll some of the closing costs into your mortgage. This will increase your monthly payment, but it may make it easier to afford the closing costs upfront.
Lastly, some lenders offer borrowers the opportunity to buydown their interest rate by paying discount points. While buying down an interest rate can be appealing in the long term because it can significantly reduce the total interest paid over the life of your loan, it can also represent a significant upfront cost.
You now understand why closing costs are an essential and unavoidable part of the mortgage process. They cover the expenses associated with obtaining a mortgage and protect both the homebuyer and the lender.
The specific closing costs you will pay depend on the type of loan you have, your property’s value, and your state’s laws. You might be able to save on your closing costs by negotiating with your lender. You may also want to negotiate with your seller to pay a percentage of your closing costs through seller credits.
Before closing, you will receive a Closing Disclosure, which provides the final breakdown of the closing costs. It’s essential to carefully review the Closing Disclosure to ensure that all fees are accurate and that there are no unexpected expenses. If you have any questions about the closing costs, it’s important to discuss them with your lender before closing.