We want to clear up some of the confusion related to the costs of buying or refinancing a home, specifically, closing costs.This information will help you as you’re budgeting for your home purchase as well as shopping for a good mortgage broker. (Hopefully you’re planning on using a mortgage broker!)
The various costs, from loan fees to taxes and more, that you must pay to buy a home are called closing costs. The same costs apply even if you are refinancing a loan, because it is an entirely new loan.
How much should you expect to pay in closing costs?
Closing costs usually range from 3% to 6% of the purchase price of the home. For a first-time homebuyer, 3% is a good starting point for estimates.
Many closing costs are fixed costs, so when the purchase price is smaller, the closing costs come out to a higher percentage; on a larger purchase price, the costs equal a smaller percentage.
Closing costs vary widely depending on many factors, such as the loan amount, local tax rates, state regulations and fees, homeowners insurance rates, how many points you’re paying or whether you’re receiving lender credits, etc. The actual costs should not usually be more than 7% of the purchase price, unless you’re paying for a lot of points (to lower your interest rate).
A Quick Example
On a loan of $350,000, you could estimate about 3% of the home purchase price as a starting point for closing costs. That would be $10,500.
For your total out of pocket costs, you would also determine what your down payment is based on your loan type and the minimum requirements. For example, an FHA loan requires 3.5% down. On a $350,000 loan, that would be $12,250. (Learn more about loan types and down payment minimums.)
$10,500 + $12,250 = $22,750 cash that you would need at closing.
Tip: We recommend you keep some savings at the time of closing. You don’t want to close and not be able to make payments right away if you had a financial emergency, such as a job loss.
You could also receive lender credits to cover closing costs and prepaid items, reducing the percentage to as low as 0%. You would be taking a higher interest rate to get lender credits.
Tip: If a seller is willing to negotiate, you can request that a seller cover some or all the closing costs as part of the purchase contract. We usually recommend this approach over asking for a price cut because you will save more money over time by reducing the interest rate or closing costs than you will by lowering the purchase price by a few thousand dollars.
4 “Buckets” of Closing Costs
There are 4 main buckets, or types, that closing costs fall within. If you’re looking at a Loan Estimate (or Closing Disclosure), you’ll find these 4 buckets on page 2, sections A through J. Three of the types are very similar across lenders, but the 4th type is where you will see differences and can negotiate with a lender. We’ll discuss that 4th type last.
Don’t have a Loan Estimate yet? Learn how to get a loan quote or Loan Estimate as you shop around for a lender.
Bucket 1: Prepaid Items (Sections E, F, G, H and I)
This bucket is for prepaid items, often called reserves, impounds or escrows. These items are found in sections E, F, G, H, and I on your Loan Estimate.
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These costs include required property expenses that the lender collects and then pays on your behalf, such as homeowners insurance, property or other taxes, sometimes HOA or other fees and daily interest owed to the lender for the first month that you move into your new home (before your first payment is due).
The lender collects your money and puts it into an escrow account, which is a savings account for you. It’s your money, but they’re holding it so they can pay your taxes and insurance when they come due. Lenders do this because it protects their investment in your home; they want to ensure that you pay your property taxes and your homeowners insurance policy.
Tip: When you have a fixed interest rate loan, the principal and interest portion of your monthly payment will never change during the life of the loan, but the escrow portion can and will change as taxes and insurance costs inevitably increase.
How much tax and insurance money will the lender collect at closing?
It varies, but typically your escrow account will start out with 15 months of homeowners insurance and 2-3 months of property taxes.
Because lenders don’t determine what your taxes and insurance costs are, these fees are going to be very similar across any lender that you work with. Taxes, of course, are determined by local and state municipalities. Homeowners insurance, however, is up to you. You can shop around to find the best rates.
If you’re shopping around for a lender and want to narrow down the differences in cost between lenders, there are two options when looking at prepaid escrow costs.
- You can ask the loan officers to line up the escrow items for the same amounts, making sure they use the same daily interest rate and number of days and the same number of months for prepaid taxes and prepaid insurance. That would require some back and forth so, we recommend option 2.
- The better option is to simply ignore all the prepaid costs in sections E, F, G, H and I while shopping around. Of course, when you prepare to close on your loan, pay attention to the prepaid costs. But when doing initial shopping, ignore these prepaid costs on a Loan Estimate or quote.
Bucket 2: Services You Can Not Shop For (Section B)
Section B contains third-party costs that the lender gets to choose the servicer for, such as an appraisal, tax service certification, flood certification or credit reporting. These costs are usually very similar across lenders, with maybe $100 variance. You can just set these costs aside when comparison shopping, because they’re going to be very similar.
Be aware that many loan officers do not include an appraisal fee on a Loan Estimate, especially if you have a higher down payment or “loan to value,” because they think they can get the appraisal waived. And that does happen at times. However, we like to see an appraisal fee disclosed because you just never know if it will be waived, and we want you to be prepared for that cost.
Bucket 3: Services You Can Shop For (Section C)
This section is where title insurance and title fees appear. There most likely won’t be a big variation between lenders here. Title insurance and title fees are highly regulated; as a result, these costs are very similar across lenders. Sometimes you’ll see a variation of a couple hundred dollars.
Title insurance is the biggest cost in section C. Title represents legal ownership, and title insurance protects your right of ownership if other claims show up down the road. It is considered optional, but we highly recommend you always buy it.
The second biggest cost section C is the settlement/closing/title fee. Usually the settlement fee is where you might see a little difference among title companies. These days, half of the title companies lump all their costs into one sum, half will break their costs out into a laundry list. Look at the total cost for section C for comparison.
You can shop for title insurance, but it doesn’t make much difference. The cost of title insurance will be mostly the same across lenders. Your loan officer can make recommendations (or may even choose one without asking you), and they may choose a reputable title company with a convenient location for your closing.
Bucket 4: Lender Fees/Origination Charges (Section A)
Lender fees and origination charges are found in section A in the upper left-hand corner on page 2 of a Loan Estimate. Pay close attention to these costs, because this is where you’ll see differences between lenders. This is where you have negotiating power.
Origination charges can appear as a few different kinds of fees:
- There is usually a flat lender fee in section A. It may be called different things, such as underwriting, admin fee, funding fee, lender fee, processing fee, doc fee, etc. An underwriter spends about the same amount of time and effort on a $100,000 loan as they do on a $600,000 loan. The lender is looking to cover that hard cost, so they charge a flat fee.
Some mortgage brokers or lenders will have what they call a “no cost” loan option. In that case, they’re building their fees into the interest rate, which increases the interest rate. We recommend speaking with a mortgage guide to help you decide if it is better to pay the closing costs out of pocket and get a lower interest rate and monthly payment or to keep your money and pay a slightly higher payment each month. A good mortgage guide can help you calculate a breakeven point and identify the best option for you.
- The next type of lender fees in section A are called points, discount points or origination fee. They’re all the same thing. What you’re doing is prepaying interest to bring your interest rate down.
Should you pay for points? It really depends on your personal situation. Paying points may be the right thing, especially if you plan to keep the loan for a long time. A good mortgage guide can help you make the best choice for your situation. How much you do (or don’t) pay in points, along with the interest rate that generates, will usually make the key difference in your loan costs among lenders. This is probably where you will decide which lender to use (along with their reputation and experience, which are very important considerations).
- The third type of lender fees is in section J on your Loan Estimate, in the lower right-hand corner of page 2. This is where you’ll see any lender credits. You may be able to choose a higher interest rate that comes with lender credits toward closing costs. Those credits can be applied to any and all closing costs. Getting lender credits is a very cool scenario if you’re only going to keep your mortgage for a year or two or less. If you plan to hold the loan longer, you might be better off choosing a lower interest rate.
That’s it, the 4 types of closing costs. In short, pay most attention to sections A and J on your Loan Estimate when you’re shopping around (assuming your interest rate is the same, for a true comparison). The other closing costs will be very similar across lenders.
If you have questions or want to get a Loan Estimate, we can recommend a good mortgage guide.