What Are Closing Costs?

A lot of first-time buyers know they need money for a down payment.

What sometimes catches them by surprise is that the down payment is not the only money involved in buying a home.

There are also closing costs.

Closing costs are the expenses involved in setting up the mortgage, completing the real estate transaction and preparing certain property-related expenses. They are separate from your down payment, although both contribute to the total amount you may need at closing.

Let’s break down what these costs are, where the money goes and how to prepare for them without getting overwhelmed.

Your down payment and closing costs are different

This is the first distinction every buyer should understand.

Your down payment is the portion of the purchase price you are paying rather than financing.

For example, if you purchase a $300,000 home with 5% down, your down payment would be $15,000.

Your closing costs are the additional expenses associated with obtaining the mortgage and completing the purchase.

That means qualifying for a 3%, 3.5% or 5% down-payment option does not necessarily mean that percentage is all the money you will need.

You may also need funds for closing costs, prepaid expenses and the initial setup of an escrow account.

What is included in closing costs?

The exact charges will depend on the property, loan program, lender, location and transaction.

However, the costs generally fall into a few main groups.

Loan-related costs

These are expenses connected with obtaining and processing the mortgage.

They may include:

Origination or underwriting charges
Credit-report fees
Appraisal fees
Tax-service fees
Flood-determination fees
Discount points, if you choose to pay them
Other services required to complete the loan

Not every loan will have every fee, and the names of the charges can vary.

Discount points also deserve a separate conversation. They are an optional cost used to obtain a lower interest rate in some situations. Paying points may make sense, but it depends on the cost, the payment savings and how long you expect to keep the loan.

Title and settlement costs

The title company, closing attorney or settlement provider helps complete the legal and financial parts of the transaction.

Related costs may include:

Title search
Lender’s title insurance
Owner’s title insurance
Settlement or escrow fees
Document preparation
Recording charges
Survey fees when required

Who traditionally pays certain title-related expenses can vary by market and contract. The purchase agreement matters.

Government charges

State or local governments may charge fees connected with recording the transaction or transferring ownership.

These may include:

Recording fees
Transfer taxes
Other local or state charges

The amounts can vary significantly depending on where the property is located.

What are prepaid expenses?

Some of the money collected at closing is not really a fee for a service.

Instead, it is money being paid early for expenses related to owning the property.

These are commonly called prepaids.

They may include:

The first year of homeowners insurance
Prepaid interest
Property taxes due around closing
Mortgage insurance premiums when applicable

Prepaid interest covers the interest that accrues between the day the loan funds and the end of that month.

Because of that, the closing date can affect the amount of prepaid interest collected. Closing earlier in the month usually creates more days of prepaid interest than closing near the end of the month.

That does not automatically mean one closing date is better. It simply changes the timing of the expense.

What is an initial escrow deposit?

If your mortgage has an escrow account, part of your monthly payment will be set aside for property taxes and homeowners insurance.

The lender may collect money at closing to establish that account with the amount needed to pay upcoming bills.

This is called the initial escrow payment at closing.

The amount can depend on:

The property’s tax schedule
When insurance premiums are due
The closing date
The lender’s required escrow cushion
Any taxes or insurance being paid as part of the transaction

This is one reason two buyers purchasing homes at the same price may have very different closing numbers.

The property taxes, insurance premiums and timing of the closings may not be the same.

How much are closing costs?

You will often see closing costs described online as a percentage of the purchase price or loan amount.

Freddie Mac provides a general estimate of roughly 2% to 5%, but that is a planning range, not a quote for a specific transaction.

Your actual costs could be different based on:

Purchase price
Loan amount
Loan program
Interest-rate selection
Property location
Property taxes
Homeowners insurance
Title charges
HOA requirements
Closing date
Seller credits
Lender credits
Assistance programs

This is why I would rather review an actual Loan Estimate with someone than tell them to rely on a blanket percentage.

An estimate is helpful for planning. The loan documents are where we begin seeing the numbers tied to your actual transaction.

What is cash to close?

Closing costs and cash to close are not necessarily the same number.

Your cash to close is the final amount you are expected to bring to complete the transaction.

It may include:

Down payment
Closing costs
Prepaid expenses
Initial escrow deposit

Then it may be reduced by things such as:

Earnest money already paid
Fees already paid, such as an appraisal
Seller credits
Lender credits
Approved assistance funds
Other applicable credits

This is why someone might have $10,000 in listed closing costs but not need to bring an additional $10,000 on top of everything else.

We have to look at the full calculation.

Can the seller help pay closing costs?

Depending on the loan program, contract and transaction, the seller may be able to contribute toward a buyer’s allowable closing costs.

These are commonly called seller credits or seller concessions.

A seller credit may help pay for items such as:

Loan costs
Title and settlement charges
Prepaid expenses
Initial escrow deposits
A temporary or permanent interest-rate buydown when permitted

Seller credits usually cannot replace the buyer’s required down payment, and the amount that can be used is subject to loan-program limits and the buyer’s actual eligible costs.

Unused seller credits generally do not become cash handed to the buyer after closing. That is why the amount should be negotiated with the financing plan in mind.

What about lender credits?

A lender credit can reduce the amount of closing costs paid upfront.

However, it is important to understand the tradeoff.

The Consumer Financial Protection Bureau explains that lender credits generally reduce upfront closing costs in exchange for a higher interest rate. Discount points work in the opposite direction by increasing the upfront cost in exchange for a lower rate.

Neither option is automatically better.

The right structure depends on how much money you have available, the monthly payment, how long you expect to keep the mortgage and what matters most to you.

Where can you find your estimated closing costs?

After applying for a mortgage, you will generally receive a Loan Estimate.

The Loan Estimate provides important information about the proposed loan, including:

Interest rate
Monthly payment
Estimated closing costs
Estimated cash to close
Taxes and insurance estimates
Loan features

The CFPB describes closing costs as the upfront costs charged to obtain the loan and transfer ownership of the property.

Before closing, you will receive a Closing Disclosure containing the final loan details and costs. For most covered mortgages, it must be provided at least three business days before closing so you have time to review it.

Compare the Closing Disclosure with your most recent Loan Estimate and ask about anything you do not understand.

Some costs can change as the transaction develops, but there are rules governing which charges can change and under what circumstances.

How should you prepare for closing costs?

Start the conversation before you are ready to make an offer.

A lender can help you estimate:

The down payment
Loan-related charges
Taxes and insurance
Prepaid expenses
Escrow requirements
Available credits or assistance
A reasonable cash-to-close range

The numbers will become more accurate once you have an actual property, insurance quote, closing date and purchase contract.

You should also keep some money available after closing when possible.

Getting the keys is exciting, but homeownership comes with repairs, maintenance, moving expenses and all the little purchases that somehow appear during the first few weeks.

I would rather help someone build a plan that leaves them with some breathing room than have them use every dollar just getting through the front door.

The simple takeaway

Closing costs are the expenses involved in obtaining the mortgage, completing the transaction and preparing certain property-related payments.

They are separate from the down payment.

Your total cash to close may include both, but it can also be affected by deposits, seller credits, lender credits and assistance programs.

Do not assume you need only the down-payment percentage you saw online. But do not assume you need an enormous amount without reviewing your actual options either.

Get the numbers early.

If you are considering buying a home, we can look at your situation, estimate the different pieces and build a plan before you start making offers.

No pressure. Just clearer numbers.

Official resources

This article provides general educational information. Closing costs, prepaid expenses, escrow requirements, credits and cash-to-close amounts vary based on the lender, loan program, property, location and individual transaction.