Ah, those halcyon days of being a renter. They were simpler times. Times when the most complicated a lease got was when they wanted first AND last month’s rent, or when they said you could paint the walls but only if you repainted them before you moved out unless the landlord liked the new paint. ("What do you mean you don’t like neon green and purple? You could rent this place for like a hundred bucks more a month with my ridiculous color scheme!")
But there comes a time in many people’s lives when they start wondering if maybe they should stop renting and start owning; if maybe they should trade the simplicity of a rental agreement (not to mention the convenience of having a landlord or super) for the potential financial benefits of owning your own home (not to mention the freedom to paint your walls neon green and your ceilings purple).
For the first-time prospective home buyer, you’re about to encounter a whole new world of paperwork and confusing things you’ve never had to worry about before. Like amortization, which sounds like the name of a death metal band, but is actually the process by which you pay off your principal debt (the loan itself) via your fixed, scheduled mortgage payment.
But let’s put amortization (and death metal) aside, and talk about a term you’re probably quite familiar with: closing costs.
Closing costs: an overview
You’ve probably heard and even used the term "closing costs." But do you know what they are, and what they consist of? Well, closing costs are just that: costs you pay (or agree to pay) at closing. And there are a lot of them.
For example, you may have noticed that during your househunt, a lot of people were doing a lot of work for you for "free." They ran a credit check and didn’t ask you for a dime. A house inspector drove forty-five minutes just to check out the place you want to buy, and you didn’t even have to tip him. But, of course, nothing’s free. The home inspector’s not inspecting the home because he enjoys looking for termites (OK, maybe he does like looking for termites, but he’s still going to get paid for it.) Likewise, the realtors, the bank, the title company, the lawyers who created the documents, the surveyor, they all need to be paid. Plus, there are prepaid taxes. Oh, and that credit check they ran on you awhile back when you were first getting qualified? That’s in there, too. (Did you accept coffee when they offered it to you during your initial meeting with the loan officer? You did? Well good for you: coffee is rarely if ever included in closing costs, which is why you should ALWAYS ACCEPT COFFEE.)
It’s a little bit crazy when you go into how many different fees comprise closing costs. Some of them small, some not. There’s no definitive list of all the kinds of fees you pay during closing. The particulars of your closing costs will depend on everything from where you live to what kind of deal you’ve struck with the buyer and/or the bank. (For instance, in some cases, you can lower your interest rate by paying "points" upfront—essentially, paying interest upfront in exchange for a lower rate.)
But you don’t really need to know each and every last fee. You’ll rarely be paying any of the closing fees separately anyway. So, the best way to think about it is as a single cost. And that cost is, on average, between two and five percent of the purchase price. That’s a small percentage, but we’re typically talking about a larger whole. If you buy a $300,000 house, that means you could pay up to $15,000 in closing costs.
In other words, closing costs should not be overlooked. They are not the equivalent of a little bit of sales tax that you hardly notice when they ring you up at your local coffee shop. (Also: why did you buy coffee at your local coffee shop? You should have gotten it for free from your mortgage guy.)
That said, sometimes closing costs are downplayed. Here are three ways they’re often downplayed, but why you should still be aware of them.
"The seller pays the closing costs."
You’ve probably heard this a lot. Make no mistake about it, this is a good thing for you, the buyer. But it’s also a little bit of an illusion. Or, more accurately, a tactic. In a seller’s market, a seller might get over their asking price and have backup offers. In that case, don’t expect they’ll be paying your closing costs. However, if a seller does not have a bidding war, and is working hard to close the deal with you, you may get them to pay your closing costs. However, that’s almost always tied to them saying "no" to your request to lower their price. So let’s go back to that $300,000 house. You may have wanted to get it for $290,000. If the seller wants to keep the sale price at $300,000, they can counter by keeping the price but paying your closing costs.
Also, be aware that this tactic may swing more in your favor, or more in their favor. Again, let’s say you were hoping to nab that house for $290,000 instead of $300,000. Sure, your closing costs could be as high as $15,000. Or, they could be closer to $6,000 (or maybe even less). In other words, if you pay $10,000 more than you wanted on your house, in exchange for the seller paying your closing costs, it’s likely they’re the ones who got the better deal.
"Roll most of it into the loan."
So you’re going to buy a $300,000 house, and as such you’ve set aside a whopping $60,000 as a 20% down payment. And now here you’re told that you owe somewhere around $10,000 in closing costs! Whoa, now you’ve got to come up with $70,000 in all? "No worries. We can roll a lot of this into the loan," you might hear. Ah, what a relief! Well, it’s a relief in terms of how much cash you’ve got to come up with right here, right now. But, rest assured, those costs are there. And now that they’re part of your loan, you’re paying even more for them because you’re also paying interest on them. It’s kind of like putting it on a credit card. A credit card that you don’t pay off for 15 to 30 years.
"It’s a no-closing-cost mortgage."
Well this seems like the perfect solution, doesn’t it? Want to avoid closing costs, just get a no-closing-cost mortgage, right? Wrong. This type of mortgage doesn’t really get rid of your closing costs. Rather, it does the same thing as the above: it rolls those costs into the loan. And it does this by giving you a higher interest rate. A higher interest rate means you pay MORE per month (every month), of which LESS goes toward the actual house you’re buying, and more towards all those closing costs you supposedly didn’t have to pay for. Really, a "no-closing-cost mortgage" is a total misnomer. Like "amortization," which by all rights should totally be a death metal band, but instead is some death-metal sounding word for how you pay off your debt.
Closing costs aren’t bad, sketchy things, and they’re not intended to be hidden costs that take advantage of anyone. They’re all legitimate fees because, the fact is, buying and selling a home takes a lot of work, and the people doing that work need to be paid for it. And as we just learned, no matter how you spin it, they will be paid, no matter what. The good news is that your lender should give you a GFE ("good faith estimate") when you qualify of what your closing costs might be.
The GFE is not a guaranteed number by any means, but it should at least be a rough idea—and fair warning.
Image: Jessica Wilson