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What Are Closing Costs?

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What are closing costs? This is one of the most important questions any would-be homebuyer needs to ask.

Closing costs are transaction fees you'll pay when you buy a home. They can include everything from inspection fees to loan fees to a government recording fee. Generally, you'll pay closing costs when you go to a lawyer's office or a title office and complete the transaction that transfers ownership.

How much are closing costs?

Zillow estimates that closing costs can add up to around 2%-5% of the purchase price of your home. You'll generally need to pay all of your buyer closing cost expenses out of your savings.

In some cases, it's possible to borrow to cover some or all of your closing costs. However, this is usually a bad idea. It could raise your monthly payment, and you'll pay interest over decades on the expenses. Trying to finance closing costs could also affect your loan-to-value ratio.

What are the closing costs you're likely to owe?

If you're wondering exactly what are the closing costs that you're likely to incur as a homebuyer, read on to find out some of the most common fees. You won't necessarily have to pay all of these costs for every transaction, but it's inevitable you'll incur at least some of them.

Closing fees

Fees need to be paid to whomever facilitates the completion of your transaction. In some states, a title office handles the closing process. In others, you'll need an attorney. Either way, you're going to pay someone who has the authority in your state to finalize the transfer of the real estate you're buying.

Attorney's fees

Even if you don't need a lawyer to close on your home purchase, you may still have to pay for an attorney. You could incur fees if you have a lawyer review the purchase agreement, or if you need legal advice on any other aspects of the purchase (such as how to structure the ownership of your home).

Loan application and origination fees

Most of the best mortgage lenders charge no origination fee or application fee, or they charge only a very low fee. However, some mortgage companies impose higher up-front costs just for applying for a loan.

Even if you apply with a mortgage lender that charges few fees, you'll likely still owe for some costs associated with obtaining a mortgage loan -- such as the cost of obtaining your credit score.

To find the right mortgage lender, get quotes from multiple lenders. That way, you can see which loan option makes the most sense for you as a borrower.

Underwriting fees

Lenders go through an underwriting process before finalizing your mortgage. During this time, the lender will investigate your financial situation to determine the risk that you'll default on your loan. Many lenders charge you underwriting fees to compensate for time and money spent on this process. You'll find out these fees in your closing disclosure from your mortgage lender.

Mortgage discount points

Some, but not all, borrowers will pay mortgage discount points when they obtain a mortgage. Points are essentially prepaid interest. You pay upfront to buy down the interest rate on your loan so you can pay less in interest over time.

Points typically cost 1% of the loan amount. On a $100,000 loan, buying a point would cost you $1,000. Points reduce your rate by an amount determined by your lender. It's common for points to reduce your rate by 0.25%. So your loan might go from 3.25% interest to 3.00% interest in exchange for paying a point.

You'll have to pay points as part of your closing costs if you decide to buy them, but the cost is usually tax deductible. The longer you stay in your home, the more sense it makes to buy points. Do the math to find out if buying points is worth it by dividing the initial cost of the point by the monthly savings you receive because of it.

If a point costs you $1,000 and reduces your monthly mortgage payment by $15, it would take you 67 months to break even ($1,000 /15). If you don't plan to stay in your home for that long, buying a point isn't worth it. If you plan to stay longer, it makes sense because you'll continue to enjoy lower payments even after saving enough to make up for your initial investment.

Credit report costs

If the cost of obtaining your credit report isn't included in the loan application or origination fee, you'll need to pay for this separately as part of your closing costs. You'll pay for the cost of obtaining a credit report for each of the co-applicants if there is more than one borrower taking out the loan.

Appraisal fee

Mortgage lenders require you to have the home you wish to buy appraised. An appraisal involves a professional looking at your home's features and comparable sales to estimate the market value.

Lenders use appraisals to decide how large your home loan can be, as they won't give you a mortgage for more than the home is worth. The home serves as collateral to secure the loan. If you aren't able to pay back what you owe, the lender will resell your home to help pay off loan. And if the lender can't resell the home for the amount of your mortgage, they'll lose money.

When the appraiser determines what the home is worth, your lender will lend you a certain percentage of its market value. Typically, lenders like to cap the amount they'll lend you at 80% of the home's value. This would mean you have an 80% loan-to-value ratio, and you'd need to put down a 20% down payment.

However, you can get FHA loans with a low down payment or VA loans with no down payment. Lenders offering FHA or VA loans with low down payment requirements are often some of the best mortgage lenders for first-time borrowers. However, some conventional lenders also offer loans with as little as 3% down.

If you put down less than 20% of the appraised value of your home, you'll generally need to pay private mortgage insurance (PMI) to protect the lender.

Appraisals can cost several hundred dollars, but you won't be able to get a loan without paying for one.

Inspection fees

Mortgage lenders also want to make sure the home you're buying has no major problems. As a result, you're typically required to pay for a home inspection to check out the house. This can also cost several hundred dollars.

In addition to a basic home inspection, you may also need to pay for additional specialized investigations. For example, you may choose to obtain -- or be required by your lender to obtain -- an inspection aimed at determining if there's any lead-based paint in the home or to determine if there are any pests in the home.

Survey costs

Your lender will generally require you to have a survey done of the property. The purpose is to determine where the property's boundary lines are. If there's a dispute over where the property ends or if your neighbors have encroached upon the property -- say by building a driveway that's a little bit on your land -- the survey will reveal the issue so it can be addressed before closing.

Flood determination fees

In many cases, you're required to pay a fee to find out if the home you're buying is located within a flood zone. If it's determined your home is prone to flooding, your lender will require you to buy flood insurance before you can close on the home.

Deposits into an escrow account

In many cases, your monthly mortgage payment also includes property taxes, private mortgage insurance, and homeowners insurance. Money for insurance and property taxes is then put into an escrow account. Your lender holds those funds until your taxes or insurance premiums must be paid.

When you buy a home, you'll likely need to prepay the cost of insurance and taxes for several months as part of your closing costs. You'll need to bring this money to closing so it can be deposited into your escrow account. Your loan officer should tell you up front how much you'll need to put into escrow depending on the policies of the mortgage company.

Property taxes

If the seller paid property taxes for the entire year, you may need to pay back a prorated amount of these taxes. The amount you pay will depend on when you purchase the home. If any taxes are due within 60 days of closing, you'll generally be required to have funds for those as part of your closing costs as well.

Insurance premiums

You'll be required to pay homeowners insurance before closing on your home. Your lender wants to make sure the property is covered right away. You may also be required to pay for flood insurance if your home is found to be in a flood zone., so it's important to determine how much home insurance you'll need.

You'll pay premiums to buy your policy as part of closing costs. These premiums may be paid directly to the insurance company or be put into escrow, depending how your mortgage loan is structured.

Private mortgage insurance

When you put down less than 20%, you'll have to pay PMI. You'll likely need to pay at least a month or two of PMI premiums up front as part of your closing costs. This money could be paid into your escrow account or directly to the insurer, depending on how your loan is set up.

Title insurance

Lenders also require you buy a title insurance policy when you buy a home. The title to your property determines the rights you have with regards to the property. A title search is performed when you buy a home to see if there are any claims on the property you weren't aware of. This search is supposed to find things such as easements or liens on the property.

If something is missed during the title search, it could cost you a fortune to fix the problem -- you can't buy more rights than the seller has. The easement or lien won't disappear when you purchase the house, and you could be unable to use your property as intended or have to pay someone else's debt for the lien to be lifted. If the person who sold you the property wasn't actually the legal owner, you may not even own the property at all.

Title insurance protects you in case something is missed. The insurer would have to pay any expenses associated with fixing problems with the title.

Title search costs

You'll not only need to pay for title insurance as part of your closing costs, but will also need to pay the company that performed the title search. Attorneys or title companies conduct title searches, depending on where you live.

Homeowners association fees

Sellers generally pay a transfer fee to their homeowners association, which pays for the creation of a report showing dues are current. New homebuyers may also have to prepay some HOA fees as part of closing costs. These fees are sometimes collected as part of escrow, or could be paid directly to the HOA.

Special fees for government-backed loans

The U.S. government makes it easier for people to get mortgages by guaranteeing certain loans. The Federal Housing Administration (FHA) guarantees loans, as does the Veteran's Administration. An FHA loan or VA loan can be easier to qualify for than conventional loans because the government insures the lender against loss.

But FHA and VA loans come with up-front fees that are part of your closing costs. While these fees can be financed as part of your loan, this means paying interest on them for many years. Try to pay them up front if you can to avoid a higher monthly payment.

Recording fees

When you've purchased a property, a new deed will need to be recorded. This money will be paid with your closing costs. Your city or county maintain deeds and public land records, so your fee will go to the local recording office.

Transfer taxes

Your county will likely charge a transfer tax when the property is sold and transferred to a new owner. Transfer taxes vary depending on where you live.

Courier fees

Courier fees are fees paid for documents associated with your loan to be transported to appropriate parties. This could cover costs for transmitting documents to lenders, or to the county where the deed needs to be recorded.

Be prepared for closing costs

What are closing costs? Now you know the answer and, as you can see, there are a lot of closing costs you have to pay when you buy a home.

With so many different fees and expenses, it's no wonder closing costs could add up to as much as 5% of your home's value. You need to cover closing costs before you start shopping for a home so you aren't hit with unexpected expenses you can't afford to pay.

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