What Are Closing Costs and Prepaids On a House - AND Why Do You Have to Pay Them?

Closing costs and prepaids: let's break these down.

No one works for free, right? So the people and companies that provide services that allow you to close or settle on a home have to get paid by somebody. That somebody just might be you, so let’s see what these are all about….

First of all, when I write a contract on a home, I ask the seller to pay all my closing costs and prepaids. It is currently a seller's market in many parts of the country, so the answer may be "No". Or they may come back and say they will pay half. Or they may surprise you and say they will pay all of them for you.

One strategy is to offer a lower price on the house but say you will pay your own closing costs and prepaids. The lower the price of the house, the less you will pay over the long run, so if you have the money to pay your own closing costs, this is a sound strategy.

People often wonder "what percentage are closing costs?" They are not a straight percentage. Some things are a percentage of your loan amount, for example, but most are not. Plan to pay 2% to 5% of the home's purchase price in closing costs. If the seller agrees to pay some or all of them, then you will only be responsible for what they aren't paying.

Wondering if you have to pay that fee? Here are some of the costs you may well see as you move through the homebuying process.

· Credit report fee – The lender may charge you to pull your credit as part of the very beginning of your loan. The lender is being charged by the credit bureau for this regardless, but only some lenders pass the cost on.

· Appraisal fee – Most mortgages will require an appraisal. As you trade up in the future and hopefully your credit will be even better than it is now, you may see that the lender is able to waive the appraisal. This is strictly for borrowers with excellent credit and a large down payment or equity in the home. An appraisal ONLY verifies that the home is worth at least what you are paying for it, it is NOT a home inspection.

· Home Inspection – Not required, but HIGHLY recommended, even for new construction. There are plenty of builders that cut corners, don’t kid yourself. The inspector should only be hired by you! Don’t let the seller or realtor decide on or recommend the inspector! Why?

Because they might choose people that are going to skim over issues in order to make the closing go more smoothly. Realtors don’t like inspectors that are “too picky”. You, on the other hand: the pickier the better, right? The home inspector needs to be working for YOU only.

The inspector should bring up every single thing wrong with the house, no matter how minor, so you are going into this with your eyes open. If the inspection shows that there are major/expensive things that need to be fixed that the seller won’t fix, make sure your contract is written so that you can get out of buying the house if you want to. According to USA Today, a new roof can cost anywhere from $5,435 to $37,266, with most homeowners paying an average of $21,440. Sometimes insurance will pay for it, sometimes not. And there's always a deductible you will pay if your homeowners insurance pays for it.

· Real estate commissions – The Realtors have traditionally been paid by the seller of the property. This long-standing rule was recently turned on its head by a major lawsuit. That is another story…but you may want to or need to pay some realtor fees or commissions as part of your home purchase. Remember the realtors don’t get paid unless you buy a house, so they have an incentive (which may go against what is best for you) to move forward, always.

· Attorney or Settlement Agent Fees – Whoever closes your loan gets paid to do it.

· Origination Fee/Processing Fee – The lender will charge some fees so they can pay the people that work on your loan.

· Title Search – There will usually be a separate fee for the title search. It may get rolled into another fee, but the title will always be searched to make sure there are no mortgages or liens or other owners that haven’t been disclosed so far. Even if you are not getting a loan, always get the title searched.

· Lenders Title insurance – The lender currently requires title insurance to do the loan. This insures them if mistakes were made at the courthouse or by the title searcher, if all the property owners aren't disclosed, or if liens get filed between the time the title search is done and when you close.

· Owners Title Insurance – It is OPTIONAL that you purchase owner’s title insurance. If you are purchasing new construction, you may want to buy it in case the builder hasn’t paid all the subcontractors that worked on your house. As someone who has been in the business over 40 years, I usually don’t buy it. It is a lot of money for a very low likelihood you will need it. Your closing agent will usually push you to buy it because they get part of the premium. I would buy it if the home is being sold out of an estate (one or more of the actual owners of the home is deceased). One of the things title insurance covers is heirs that come out of the woodwork and say they didn’t get paid when the house was sold.

· Survey – Surveys are not required, but you may want one, especially if you plan to put in a fence or outbuilding. You want to make sure you are inside the property lines when constructing such things. Surveys are generally interesting though, and I do like to have one. I always ask if the seller has one already. They will usually share it for free. Ask before you sign the contract, while they are still in a helpful mood!

· Prepaids – These are amounts used to pay two things: the interest you pay on the loan at closing and if you will have an escrow account to pay your taxes and homeowners insurance, it is the initial deposit for that account. (If the property is in a flood zone, you will be required to have flood insurance as well.) These amounts are controlled by law, and the lender can only charge the allowed amount. Other items that are considered "prepaids" are any property taxes and insurance amounts that are due at closing/settlement.

· Mortgage Insurance/FHA MIP – If you are putting down less than 20%, you will probably have mortgage insurance. This covers the lender if you default on the loan. Since history shows the lower the down payment, the likelier the loan is to default, mortgage insurance helps protect the lender from that risk.

· Homeowners Insurance – You will be paying the first year of your homeowners insurance. If you have a loan, you will have to have homeowners insurance. Homeowners insurance covers things like fire, falling water or trees. It doesn't cover rising water. You need a flood insurance policy for rising water.

· Flood Insurance – Not required if the property is not in a flood zone. (Flood insurance covers RISING water; Homeowners insurance covers FALLING water.) If you are near a large body of water, you may want to purchase it even if you aren’t in the flood zone. Flood insurance is pretty cheap if you are not in a flood zone.

· VA Funding Fee – Charged by the VA to help cover the cost of their home loan program. Disabled Veterans don't have to pay it.

· County Recording fees/City/State stamps and taxes – The municipal area that the property is in and the state will charge some fees and these are not optional, unfortunately.

· Discount points – If there is extra money to pay discount points (either from your savings or the seller has agreed to pay some costs), these are helpful in saving you money over the time you have the loan. They “buy down” your interest rate. A good Loan Officer will share where the sweet spot is: where you are getting the lowest rate for the least amount of money.

· Buydown fees or points – Not the same as discount points. These become popular when interest rates are high-ish, as they are now. They TEMPORARILY give you a lower interest rate, usually for the first 1 – 3 years of the loan.

This is not a complete list. There are plenty of “junk” fees that are charged by the lender and the closing agent. If you don’t know why you are being charged something, ASK ABOUT IT. Be an educated consumer!

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