Closing Costs and Lender Credits

Most homebuyers start by shopping for the lowest mortgage rate available when they start shopping for the best home loan. However, the loan’s closing costs is just as important, and it is critical that you are aware of the financial commitment before you decide to move forward with any mortgage lender. So how do you calculate closing costs? Here are a few tips to ensure you understand closing costs on your home loan and how much you will need when you are ready to close on your new home. 

Nailing down closing costs can be a challenge because different people will consider different loan fees as closing costs. Some people even consider down payment part of closing costs. While your down payment is needed at or before closing it is not considered a closing cost. We’ll cover the cash needed at closing further down. 

According to the Consumer Finance Protection Bureau (CFPB), closing costs are fees paid when closing on a mortgage loan. Although closing costs are fees paid when financing a home, not all closing costs are paid by the homebuyer. Some fees can be paid by others such as the home seller, the real estate agent(s), the mortgage broker or lender, a family member, or by a home loan grant. Regardless of the person or entity that pays any portion of your closing costs, the cost of any service charge involved with the mortgage transaction will be disclosed on the Loan Estimate (LE) and properly accounted for and balanced on the Closing Disclosure (CD).  

There is a simple way to calculate closing costs without learning to interpret a loan estimate. If you remember that closing costs, aside from what is in section A of the LE’s page two, will be similar from lender to lender, then your only task if figuring out lenders fees. Although lenders can estimate higher or lower third-party fees than another, those fees are not lender fees and are not something you can negotiate with a lender. There are four categories you can account for when you are trying to estimate closing costs and how much cash you need for closing. This breakdown can be used for home purchase loans, refinances and cash-out home equity loans. The four categories are down payment, lender fees, third-party fees, and escrow deposit. Calculating the cash needed for closing can help you budget for your home purchase or help you get an understanding of how much you will need if you are requesting down payment assistance. 

The amount of down payment needed is usually where homebuyers start the homebuying process. However, this will cover how to calculate the cash needed for closing, and a simple way to compare mortgage lenders. To calculate down payment, multiply the purchase price you are requesting by the percentage of down payment you plan on leaving on the home loan. If you plan on buying a $500,000 home on a conventional loan with a 3% down payment, then this is the calculation you would use - $500,000 x 0.03 = $15,000. This is the amount you will bring to closing and the amount of home equity you should have on the first day you own your home – assuming you paid market value for the home. Talk to your loan officer if you plan on requesting down payment assistance. You can skip this step if you are shopping for a refinance loan or cash-out home equity loan. 

This is the amount that you should be using to compare lenders when you are shopping for the best mortgage lender. Don’t forget, you still need to compare APR and APY. You can always check current market rates without impacting your credit. Section A of the loan estimate is where you will find lender fees. These fees are specific from lender to lender and can vary by thousands of dollars. The fees you might see are origination fee, underwriting fee, processing fee, administration fee, etc. If you understand each fee, then you are better equipped to negotiate the lowest cost home loan.

Origination Fee

Most lenders do not charge an origination fee. It is common to see an origination fee if you are working with a commission loan officer. In this case, the origination fee is the fee you are paying to the loan officer for assisting you with the loan. Since the loan officer spent the time and effort originating the loan for the lender, the origination fee is their compensation. It is likely you can negotiate a lower origination fee or no origination fee if you see this in section A of the LE. This is important because 1% origination fee can cost you thousands of dollars, and the origination fee does not help you get a lower rate like discount points do.

Discount Points

Discount points are different than an origination fee. Also known as a rate buydown, buydown, or points, discount points are meant to reduce your interest rate. Important: retail lenders use discount points to offer rates that compete with wholesale mortgage brokers. Wholesale mortgage brokers can offer lower rates without discount points. In general, each discount point could reduce your rate by .25%. This is not an exact formula. Talk to a licensed mortgage loan officer to get exact information about how much a discount point will reduce your rate. One discount point is equal to 1% of your loan amount. Paying a discount point to reduce your rate is an effective way to save money over the life of your loan. Again, talk to your state licensed loan officer about the benefits of discount points based on your specific goals, and about the breakeven timeframe to ensure you will see the overall savings. 

Miscellaneous Fees

Other fees that can be found in section A are miscellaneous fees such as processing fee, administrative fee, underwriting fee, etc. Regardless of the fee’s name, it is normal to see these types of fees in section A. However, the sum of these fees, on average, is approximately $995. Most lenders have an underwriting fee. An underwriting fee can be waived. Though the underwriting fee waiver is usually a trade-off for a slightly higher rate. Processing fees are usually added on to your closing costs if your mortgage lender does not have an in-house processor. 

Third-party fees account for all services necessary to underwrite your mortgage loan. Examples are an appraisal, a tax certificate, title search, title insurance, title endorsements, credit reports, government recording of deed and mortgage, and survey. It may seem like a lot, but some of these fees might be paid by other parties involved in your home loan through closing cost credits. Although some of these fees are from services you can shop for, most of these fees on the loan estimate will not vary much from lender to lender. And they are likely to fall within the cumulative tolerance category. This means they could be slightly overestimated to avoid cost-to-cure fees. 

This is a very important part of calculating closing cost for two reasons. First, although they are categorized as a closing cost, escrow fees are items you would pay for whether or not you financed your home or paid in cash. Second, adding escrow to your monthly payment can be optional. Therefore, waiving escrow would eliminate this cost. Furthermore, if you paid the loan off at any point, your escrow account balance would be refunded to you directly. This is a common occurrence with refinance mortgages. 

There are three parts to escrow fees. The first is your homeowner insurance binder. Your processor might refer to it as your HOI binder. This is the proof that you will have adequate homeowner’s insurance on the day you sign for your loan. Your insurance agent will usually request that you pay the entire year’s premium up-front in order to start the policy. You can pay it when you get the quote, but most homebuyers pay it at closing, therefore it adds to the amount of cash needed for closing. Talk to your insurance company about policy payment options. 

Second, although you pay an entire year to start your HOI policy, you will be required to deposit approximately two more months’ worth of HOI premium to start your escrow account because you will not have a mortgage payment for at least 30-days after you close. Therefore, you will need to have enough funds in your escrow account next year to cover an entire 12 months of HOI. If you did not leave a two-month deposit, then you will likely be short two months when your HOI renews the following year due to the delay in the first mortgage payment due date. 

The third part of your escrow fees is the property tax deposit. Although you are only responsible for the portion of property tax from the day you close on the home to the end of the year, there will be a gap between your closing date and your first mortgage payment. Therefore, you will likely need about three months’ worth of property taxes deposited into your escrow account to ensure your tax bill is not short. If you purchase towards the end of the year you might see a huge tax deposit into escrow. Do not panic, you will see a seller credit to cover the portion of taxes owed prior to your closing date.

With a good understanding of the costs associated with buying a home, it is time to figure out what fees can be paid by others. After seeing the sum of the down payment, lender fee, third-party fees, and escrow deposit, you might feel overwhelmed with the decision to buy a home. However, credits applied to your loan can help reduce the amount of money you will need to bring to closing. Do not worry if a few credits are missing on the LE. With your loan officer, loan processor, loan underwriter, title company, and closing department all looking over your file prior to closing, it is extremely unlikely any credits will be missed. Be sure you talk to your loan officer if your LE is lacking any credit. Although an LE can be revised, the initial LE will need acknowledgement prior to requesting an update. 

Deposits such as earnest money and option fee are credited back to you and will reduce the cash you will need for closing. Earnest money deposit amounts can range. However, expect to leave about 1% of the home’s purchase price with the title company handling the escrow. Sometimes your loan estimate is issued before your lender is aware of the earnest money deposit or option fee amount. The LE will have the estimated funds needed to close, you can reduce that by the amount of deposit you left with title. Since the title company handles the escrow portion of the loan, there is no way your earnest money or option fee will be missed. 

It is possible that the title insurance policy will be paid for by the seller. Depending on whether it is a buyer’s market or seller’s market, having the seller pay for the title insurance policy is common. Talk to your real estate agent about the title policy. If you are unsure about the cost of title insurance, you can ask your loan officer or loan processor. Having the seller pay for title insurance can reduce your closing costs by thousands of dollars.  

Even though a seller covers the cost of title insurance, you are still able to negotiate seller’s concessions to help reduce your closing costs. Important: seller’s concessions can only assist with closing costs and cannot be used to cover any portion of the required down payment. Seller’s concessions are limited to 3% or 6%, depending on your loan type and LTV. Your closing costs may not be that high if you work with a wholesale mortgage broker. Therefore, you may be able to use excess concessions for a rate buydown or temporary 2-1 buydown. In the example above, buying a $500,000 home with 3% seller’s concessions will give you a seller’s credit of $15,000. That amount will exceed all closing costs. The surplus, if not used, will be lost. Talk to your loan officer if you plan on negotiating seller’s concessions so you can get the most out of the seller’s credit and keep your closing costs as low as possible. 

Work with a mortgage lender or mortgage broker you feel comfortable with because a lender credit can be extremely helpful when used properly. A lender credit is a credit that can be used to reduce the loan’s closing costs. A lender credit comes from the difference between the rate you qualify for and the rate you select. Since a mortgage broker cannot make money off of the rate you are offered, the credit from the difference in rate can be credited back to you. Here is an example, if a retail rate is 5.75% but a wholesale rate is 5.25% and you are happy with the mortgage payment at that retail rate, then you could consider asking your mortgage broker for the 5.75% instead of the 5.25% and use the credit from the rate difference to credit your closing costs. Ideally, if you work with a wholesale mortgage broker, then you will have more flexibility with larger lender credits because there is a larger gap between wholesale and retail mortgage rates. 

Other options that could reduce your closing costs are down payment assistance loans, grants, and second mortgages. Be cautious that you understand how each loan program works because you might be offsetting closing costs with a DPA but paying more over the life of the loan. Talk to a state licensed mortgage loan officer if you plan on taking advantage of a second lien of any type. We recommend saving for the minimum down payment required by the type of loan you select and working with your mortgage lender if you need help with closing costs. You will put yourself in a better position when you borrow less and at a lower rate.