When you take out a mortgage, whether it’s for a purchase or a refinance, you must pay “closing costs,” which can vary considerably from transaction to transaction.
There are fees that must be paid to the bank/lender, along with optional ones, such as mortgage discount points, and fees that must be paid to third parties, such as title/escrow and insurance.
Whether you pay these fees out-of-pocket is another question, but either way there will be a cost, and you must pay it in one way or another.
Two Types of Closing Costs – Recurring and Non-Recurring
There are two main types of closing costs, including “recurring closing costs” and “non-recurring closing costs.”
Recurring closing costs are those that will be charged more than once, whereas non-recurring closing costs are charged just once.
Here are some examples of recurring closing costs (paid more than once):
– Homeowner’s insurance
– Mortgage insurance
– Flood insurance
– Property taxes
– HOA dues
*Note that not all fees are necessarily applicable depending on the property, location, loan type, etc.
Here are some examples of non-recurring closing costs (one-time fees):
– Lender fees (underwriting, processing)
– Loan origination fee
– Mortgage discount points
– Credit report fee
– Appraisal fee
– Home inspection fee
– Termite inspection fee
– Building record fees
– Title and escrow fees
– Doc prep fees
– Recording and wire fees
– Notary and messenger fees
– Transfer taxes
As you can see, there are quite a few costs associated with obtaining a mortgage, and not everyone has the cash on hand to pay for all these fees. There are also those who like to hang onto their cash and put it elsewhere.
If you want to reduce your closing costs, there are number of strategies to do so.
Use Seller Contributions to Cover Closing Costs
One of the most common ways to reduce your out-of-pocket closing costs is to get a contribution from the seller (if it’s a purchase transaction).
These so-called “seller contributions” or interested party contributions (IPCs) can be used toward the closing costs mentioned above, but cannot be used for the down payment or reserves, nor can they wind up in the buyer’s pocket.
Note that while seller credit can’t be used for down payment or reserves, it can free up your own cash to use toward down payment and/or reserves that may have otherwise gone toward closing costs.
When negotiating a sales price, the buyer and seller can discuss these contributions, and their presence will likely lead to a higher contract price.
As a result, the buyer still pays the closing costs by accepting a higher loan amount associated with a higher purchase price. However, the costs aren’t paid at settlement, so it’s easier for the buyer short on cash.
It’s also possible to get a seller credit for repairs that come up during the inspection, which is why it’s so important to take the inspection seriously. If you’re buying a home, you may actually conduct 3-5 different inspections for separate items like the pool/spa, roof, termite, chimney, and so on.
This is your chance to get money for the many things that might be wrong with the house. Once you present the seller with a request for repairs, they’ll likely offer a credit that you can use toward closing costs or to lower the purchase price. Or both.
The maximum amount of seller contributions allowed will vary based on the type of loan (conventional vs. FHA), the property type, and the LTV ratio. The lowest amount allowed is 2% of the purchase price, and the highest allowed is 9%.
Get a Lender Credit to Offset Closing Costs
Another way to reduce or eliminate your out-of-pocket closing costs is via a lender credit, which is essentially agreeing to take a higher mortgage rate in exchange for lower settlement costs. This works on both purchases and refinances.
For example, a lender might tell you that you can secure an mortgage interest rate of 4.25% paying $5,000 in closing costs, or give you the option of taking a slightly higher rate, say 4.5%, with a $3,500 credit back to you.
If all your costs are paid via a higher rate, it’s a no cost loan, though sometimes this definition only covers lender fees, not third party fees.
Either way, you’ll pay a bit more each month when making your mortgage payment, but you won’t need to come up with all the money for the required closing costs.
Again, your out-of-pocket costs are reduced here, but you pay more throughout the life of the loan via that higher mortgage rate. That’s the tradeoff.
Ask for a Credit from Your Real Estate Agent
Another way to reduce your closing costs (not just out-of-pocket) is to ask your real estate agent to give you a credit toward closing costs.
If they want your business, or just want the transaction to close, they might be willing to part with some of their commission to help you with closing costs.
For example, if they’re earning 2.5% to close the deal, they might be willing to give you 0.25% of that to help with your closing costs. Sometimes both agents will get together and give a small portion of both commissions to the buyer to get the job done.
And this will actually reduce what you pay, as you won’t take on a higher interest rate or pay for the costs via the loan.
Just be careful when combining credits to ensure they don’t exceed the maximum allowed by the lender. Assuming you find that you’re leaving money on the table, consider using the excess to buy down your mortgage rate or to cover prepaid items like escrows.
Negotiate and Shop Your Closing Costs
It’s also possible to shop around for certain settlement costs, instead of just blindly using the companies your real estate agent recommends.
For example, you can comparison shop for title insurance and/or your homeowner’s insurance and save on costs there. The same goes for your home inspection.
If refinancing your mortgage, ask for the “reissue rate” or “substitution rate” when purchasing the lender’s title insurance policy. There is no reason you should have to pay full price again for a title search when you’ve been the only person living in the property. This could save you a significant amount of money on closing costs with as much as a phone call to the title company.
Similarly, when looking for a bank to work with, be sure to look closely at the fees they charge. They don’t all charge the same fees or the same amounts, so finding a lender with a low rate and low fees could save you big.
Also watch out for unnecessary junk fees, which can really add up. But remember that certain closing costs just aren’t negotiable, like property taxes.
There are a few other ways to cut down on closing costs. Prepaid interest, which is the per diem interest due between the time you close and your first mortgage payment, can be costly depending on the size of your loan and when you close.
If you close near the end of the month, you can greatly reduce the number of days of per diem interest due at closing. This can significantly reduce your closing costs.
However, the tradeoff is that it’s a very busy time for lenders, and they might not close in time.
For those refinancing, it may also be possible to roll closing costs into the new loan, instead of paying them out-of-pocket.
Again, the implication here is that you’ll be paying interest on those closing costs for as long as you hold your mortgage, as opposed to just paying them at face value upfront.
But it’s worth consideration, especially if you don’t plan to stay in your home, or with the mortgage very long. There’s also a thing called inflation that makes today’s dollars less valuable over time.
Lastly, check out special programs like HomePath and HomeSteps, which offer closing cost assistance if you take part in homeownership education courses. And be sure to look into state programs that offer incentives to first-time home buyers.