Understanding Closing Costs

If you're a potential first time homebuyer, you may be confused about those mysterious closing costs--the expense that means that when you thought you'd finally saved up enough for a down payment, you really hadn't. Closing costs can add 2% to 5% to the purchase price of your home, which is especially painful if you live somewhere with high housing costs.

So what are closing costs? Here's a rundown. Keep in mind that this is just a sampling of fees you may need to pay. Depending on your location, lender, and other factors, you may encounter a lesser or greater list of fees.

Credit report: For around $50, the lender will check at least two of the major credit reporting agencies (Experian, Equifax, and Transunion) as well county records (to make sure you don't have any judgments or tax liens). Basically, they want to check out your financial background to make sure you're a good candidate for a loan.

Loan origination fee: This is a fee that lenders charge you when you acquire a mortgage. Think of is as a start up fee. It includes both the cost to complete the loan paperwork and points. In a nutshell, points are a fee you can pay in exchange for a slightly lower interest rate. They're also often a major source of profit for lenders and not always a good deal for consumers. One point is equal to one percent of the loan principal.

Application fee: Yet another fee that covers the cost of processing your loan. You can expect to spend $450 to $600 on this.

Appraisal fee: If you're paying all cash, you don't have to get the property appraised, but if you're taking out a loan to make the purchase, an appraisal will be required. The lender has to protect its interest--they want to make sure the property is worth about what you'll be paying for it so that if you default on your loan (quit making your mortgage payments), they'll be able to recoup their losses when they take away your house and sell it. The appraisal can also benefit you by telling you if the seller is asking a fair price for the property. Appraisal fees will probably run you $300 to $400.

Property inspection: This is optional, but you'll definitely want to have it done (to learn why, check out my article on home inspections). A property inspection will cost you $300 to $400 and will help you learn what condition your property is really in before you make the most expensive purchase of your life.

Title search and insurance: This is another fee you can avoid if you're paying all cash, but skipping this step could really hurt you later on. A title search makes sure that no one else claims a right to your property, and the insurance protects you if something unexpected pops up after you're the new owner. The fee for both will be about .75% of the cost of your house. How could anyone else claim a right to your house, you may be wondering? One example: the previous owner of the house passed away and someone later tries to claim that they are the rightful heir of the property.

Private mortgage insurance (PMI): When you put less than 20% down on a property, most lenders will require you to purchase this insurance (another option is to get a second mortgage, but that's beyond the scope of this article). You may have to pay a year's worth of premiums in advance. This expense will vary depending on your location, but $1,000 is a reasonable ballpark figure here.

Prepaid homeowner's insurance: Lenders generally require that you pay one year's worth of homeowner's insurance in advance.

Prepaid property taxes: You may have to prepay property taxes for the time period between closing and your first mortgage payment. Also, your lender may require you to prepay one or two months' worth in addition to this amount. They may even require you to let them charge you extra to take control of your property tax payments on an ongoing basis. The good news is that property taxes are prorated for the month that you move in, meaning that the seller pays property taxes for each day that she still owns the property, and you don't start paying property taxes until the day you become the owner.

Recording and filing fees: These fees are for recording the deed of trust or mortgage (what it's called depends on where you live) and filing other legal documents.

Tax service fee: A really obnoxious fee of about $75 that is used to notify the lender if you default on your property taxes.

Transfer tax: A fee due to the county when the property is transferred. There may be an additional transfer tax levied by the city. Sometimes transfer fees can be split with the seller.

Garbage fees: Miscellaneous fees involved in processing everything listed here, such as courier and filing fees.

Other expenses you could encounter include attorney fees (if any major problems develop), assumption fees (if you're taking over someone else's loan), escrow company fees (if the title company does not handle escrow), and survey fees (if you are purchasing a house that has easements or the property lines are not clear for any other reason).

To get a sense of exactly what fees you'll have to pay in your area and what they'll add up to for a home in your price range, contact a lender or a real estate agent who works in your city. If you're new to buying a home, I also highly recommend getting a book or two from the library that will help you learn all of the new terminology you'll encounter and help you understand the purchase process. In my opinion, if you completely rely on information from lenders and real estate agents, you risk, at best, not catching a mistake, and at worst, getting ripped off at some point in the purchase process. Understanding what's going on will not only make things less stressful, but also help you protect yourself.