What Are Closing Costs?

How closing costs work

Closing costs are a collection of fees and expenses that homebuyers must pay to finalize their mortgages. They’re typically paid at the end of the homebuying process — at the closing, when both the buyer and the seller sign legal documents to transfer property ownership. As the buyer, you’ll also sign paperwork to enter into a contractual agreement with your mortgage lender.

Your lender will specify the methods you can use to pay your closing costs (usually a cashier’s check or wire transfer). Some banks require a few days’ notice before completing a wire transfer, so you’ll want to ensure you’ve accounted for that time.

Closing costs are mostly made up of lender processing fees and property fees, though they include some other fees, too. They cover services such as title searches and home appraisals, and they can also include property taxes and escrow payments for homeowners insurance premiums.

“Closing costs are dependent on many factors including credit score, how much buying power you need, how much you want to buy down your interest rate and your lender,” said Michelle Taylor, a real estate lending expert at GFS Home Loans. “A good lender will go over each fee with you and help navigate with you from the time you apply to the closing of your loan.”

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Types of closing costs

All closing costs are listed individually on both the Loan Estimate and the Closing Disclosure documents, which you’ll receive at different points in the closing process. The closing costs listed usually fall into one of three categories: mortgage fees, property fees and other fees.

Certain fees, such as the application fee, home appraisal fee and origination fee, are controlled by your lender. You can negotiate these costs directly with the lender. Other services, such as pest inspection, may be performed by any qualified company you choose. With these third-party costs, you have the freedom to shop around to find the best deals.

Itemized list of common fees

Rolling closing costs into your mortgage

Some lenders allow you to roll the closing costs into your mortgage. There are two ways to do this. Your lender might add the closing costs to your principal (this is known as financing your closing costs), or they may offer you an interest rate trade-off: lender credits that cover your closing costs in exchange for a higher interest rate.

While these cost-saving options save you money upfront, you'll either be paying interest on your closing costs or a higher overall interest rate for the life of the loan. Both will cost more in the long run.

Paying this extra interest can be especially pricey if your loan has a prepayment penalty. You should thoroughly evaluate your finances before deciding whether to roll your closing costs into your mortgage.

A prepayment penalty means you’ll be liable for an additional cost if you pay off or refinance your loan early.

To determine whether rolling the closing costs into your mortgage makes sense for you, it helps to calculate the break-even point. This is the point at which the total additional money you’ll pay becomes greater than the original amount of your closing costs.

For example, if you’re buying a $375,000 house with a $300,000 loan and closing costs of around 4%, your mortgage payment could rise by about $90 to $100 a month, depending on the zero closing cost option you choose.

This means that you’ll have paid out the same amount that you saved on closing fees after about 150 to 167 months, or around 12 to 14 years — that’s your break-even point. If you plan to sell or refinance before this point, you may come out ahead, but if you keep the same property and loan for longer, you’ll end up paying more than the upfront closing cost amount.

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How to calculate closing costs

There are two ways to calculate your closing costs. First, you can use a closing cost calculator found on many financial websites, such as Fannie Mae. These calculators use local tax and fee data to give you a reasonably accurate estimate.

Another way to estimate your closing costs is with the Loan Estimate document provided by your lender. This estimates the loan amount, interest rate, monthly payment and closing costs in the beginning. When you receive the Closing Disclosure, which finalizes the loan terms, you’ll want to compare the estimated costs with the finalized costs to look for discrepancies.

One important figure to compare is the “cash to close” amount, which is how much you’ll have to pay at closing. It’s also important to know which fees your lender is legally allowed to change after providing the Loan Estimate.

The amount by which a lender can change a fee is known as fee tolerance. Closing costs fall into three degrees of tolerance:

• Zero tolerance fees: Unless there is a change in circumstance, your lender may not alter these costs after providing your Loan Estimate. These include transfer taxes as well as fees for required services provided by your lender, mortgage broker, their affiliates or a required service provider you don’t get to choose.
• Fees with 10% tolerance: If there is no change in circumstances, your lender is limited to a fee increase of 10% or less for recording fees and fees for required third-party services provided by a company you chose from the lender’s list. However, if there is a change in circumstances, these fees can vary by any amount.
• Fees that can increase by any amount: Closing costs that your lender does not control fall into this category. These include fees for third-party services if you choose a provider that’s not on your lender’s list or if the lender does not require the service. The cost of prepaid mortgage interest, home insurance and initial escrow deposits can also change by any amount.

Not all closing cost increases are a red flag. Knowing which fees can change and by how much will help you determine whether a fee increase you’re seeing is tolerated or a violation.

» MORE: How to negotiate your mortgage closing costs

Who pays closing costs?

The buyer typically pays for the majority of the closing costs; however, there are some expenses the seller may cover (these are called seller concessions). Sellers are more likely to agree to closing cost concessions in a buyer’s market.

If you do pursue seller concessions, note that there are limits depending on your loan type. Below are seller concession limits based on mortgage type:

» MORE: Seller’s disclosure: what home sellers must reveal

How to lower closing costs

According to the real estate lending expert Taylor, “There are many ways to get help with closing costs.” She added that, “This includes government-sponsored forgivable down payment assistance programs. Realtors can [also] write offers for a seller credit to go toward that buydown and help with closing costs.” You should pursue these options as early as possible in your mortgage process.

If you want the seller to pay for some of the closing costs, you’ll have to negotiate those terms when you present an offer. Your real estate agent can advise you on typical seller concessions and help you hammer out which ones are most likely to be accepted in your situation.

You can also request reduced closing costs and waived application fees — ideally, early in the process when multiple lenders are competing for your business.

Lenders may choose to adjust or waive the fees that they control directly, like origination, application and underwriting fees. They also have control over whether they choose higher- or lower-priced providers for some third-party services, such as settlement agents. However, they can’t change per diem interest, appraisal fees or government fees such as recording fees and transfer taxes.

Don’t be afraid to challenge your lender about certain closing costs. Aaron, a reviewer from Florida, said, “I noticed my closing costs were exceptionally high, and when I inquired as to [the] reason why, they were magically able to drop them by $7000 with the same interest rate.”

» MORE: First-time homebuyer benefits

FAQ

Bottom line

Closing costs cover lender and property fees when you purchase real estate. The amount you’ll have to pay in closing costs depends on your lender, location and the type of mortgage. You can expect to receive a Loan Estimate and Closing Disclosure that spell out each of the costs you’re expected to pay with a new mortgage.

Usually, closing costs amount to about 2% to 5% of the home’s sale price. Buyers can negotiate with sellers to help pay for some of these costs, but there are limits to how much the seller can cover. The seller may, however, have the upper hand at the negotiation table if it’s a seller’s market. Ultimately, you’ll want to draw on the expertise of your real estate agent to decide the best plan of action for you.