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What Are Closing Costs?

Michele Lerner

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.

[Read: The Best Mortgage Lenders of 2018.]

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.

[Read: Best Mortgage Refinance Lenders.]

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.

[Read: How to Get a Mortgage With No Down Payment.]

"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.

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