The first question a real estate agent asks prospective home buyers: “Do you know your budget?” Followed by “Have you been preapproved?” Let’s assume you answer yes to both questions. But are you certain you really know how much house you can afford? You’ve gotten preapproved for a certain loan amount and you have a 20 percent down payment ready to go. But wait! If you aren’t informed about closing costs, you could lose your dream home before you’ve even had a chance to put in an offer.
What Are Closing Costs?
Closing costs are all of the fees associated with buying a new home. You’ll start writing checks as soon as your offer to purchase has been accepted and signed by all parties, but some builders do pay closing costs as a buyer incentive. The first check is your deposit, also known as earnest money. This counts toward your down payment and is not associated with closing costs.
Closing costs kick in right after that, some incurred during the time period leading up to the closing. Other costs are built in to the closing statement prepared by the lender, clearly defining how much money the buyer needs to bring to the table at closing.
Are Closing Costs the Same Thing as a Down Payment?
Closing costs are not part of your down payment; they are in addition to it. Your down payment goes toward the purchase price; closing costs are necessary expenditures to satisfy all the terms of the loan and to complete the contract. Understanding the costs you’ll need to cover, and ensuring that you have enough cash reserves on top of your down payment to do so is essential to closing on the home you envision for yourself and your family.
Here are some numbers to illustrate how your buying power can be affected. Let’s say you have $100,000 to use as a 20 percent down payment on a $500,000 home. You’ve spent hours poring over listings with a $500,000 filter (or maybe a bit higher, “just in case”) applied to your search. But if you don’t have additional resources to cover closing costs, you will need to revise your purchase price budget. For instance, if you earmark $10,000 to cover closing costs from that pool of $100,000, you now have a $90,000 down payment which is 20 percent of a $450,000 purchase price. See what just happened?
Which Expenses Are Included in Closing Costs?
Each transaction will vary, but here are some common closing cost expenses.
Unless you’ve agreed to an “as is” purchase price, your offer is likely contingent on an inspection. This is performed by a certified home inspector who takes a flashlight and a checklist from the foundation to the roof and everywhere in between. You are responsible for this expense. Rates vary and can include additional costs depending on the type of construction and geographic location. For instance, older homes on streets with established trees may need a sewer line inspection. The EPA recommends that all homes be tested for radon, a natural gas that is known for causing cancer.
Next up is an appraisal. Just because you agreed to pay the seller an agreed-upon price doesn’t mean it’s worth it. Your lender wants to ensure that the home’s market value is in alignment. That way, if the lender is forced to repossess the home, it can recoup its investment. The cost for an appraisal is passed on to the buyer and is usually part of the closing statement.
There are also fees associated with your loan. They may include a mortgage application fee at the front end. At closing you’ll pay an origination fee, which is a percentage of the overall loan (often referred to as “points”) and it covers the cost of processing the loan. Ask questions when shopping for a loan and make sure you understand the cost of borrowing money before you commit to a lender.
Title insurance also accounts for a hefty line item in the closing statement. This process ensures that you will actually own what you have bought. This New Home Source article explains how title insurance works and why you need it.
Some portion of property taxes is usually included in closing costs, calculated as arepayment to the seller for prepaid taxes. Remember, when it’s your turn to sell, you will be on the receiving end of this payment.
Some states such as New York charge a real estate transfer tax (a percentage of the purchase price); some cities clamor to claim their piece of the pie, too. At the closing, there are fees for attorneys and a notary, as well as the recording of the new deed. While we can’t cover every possible expense related to closing here, we do want to prepare you for the myriad demands that will be made on your available cash. Understanding the difference between the cash you’ll need to pay for closing costs and the cash you’ll bring to the table as your down payment will help you determine your buying power so you can find the home that you not only love, but can also afford.