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What are Buyer's Closing Costs?
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Closing costs are the total expenses that the buyer pays at the time a real estate transaction is completed. This stage of the transaction is called "closing." Closing costs include application, underwriting and loan-origination fees; mortgage points; title search and insurance; fees for related legal services; and costs to fund an escrow account.

For home mortgage loans, closing costs generally range between 2.7 and 3 percent of the home purchase price. These costs will itemized on a "Good Faith Estimate" that will be provided by the loan officer when the buyer seeks to pre-qualify for a loan or obtain loan pre-approval (preferred).

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The following is a alphabetical list of financial definitions dealing with the home loan process:

Accrued interest: Accrued interest is the interest expense that accumulates on your loan. For example, if you have a monthly loan at an annual interest rate of 12%, interest accrues at the rate of 1 percent per month. If your loan balance is $5,000, the accrued interest after one month is 1 percent of the loan amount, or $50. If you make a loan payment of $100, $50 will be applied to the accrued interest and $50 to reducing loan principal. In order to pay down more of your loan, you must increase your loan payment to reduce the share that is paid to accrued interest.
Adjustable-rate mortgage: Adjustable rate mortgages are called ARMs for short. The lender changes the interest rate periodically in accordance with the loan agreement. For example, the loan agreement may say that the rate on a 1-year ARM is reset every Sept. 1 after an initial period of three years. The interest rate is calculated by adding a margin to an index rate. If the margin is 3 percentage points and the yield on the 1-year bill (assumed to be the index rate) is 6%, the loan rate is reset to 9%. ARM loans usually have provisions that limit how much the loan rate can increase at one resetting and over the term of the loan.
Adjustment period: The adjustment period is the frequency that the lender adjusts the interest rate on a variable-rate mortgage loan. For example, a 1-year ARM would have an adjustment period of one year.
Aggressive qualification estimate: Mortgage lenders are more aggressive when the economy is strong. As a result, they tend to lower their loan-qualification requirements to make it easier to qualify for loan.
Amortization: Amortization is the gradual reduction of loan principal that occurs as you make periodic loan payments. Generally, the loan principal is completely amortized with the final payment. As you pay back the loan, an increasing amount of each payment is applied to principal and a lesser amount is applied to interest. Amortization is also a process of spreading a cost that is incurred upfront over the term of the loan or life of the asset.
Amortization table: Table of factors that shows how loan principal is repaid based on the interest rate and loan term.
Anniversary date: Anniversary date is the periodic date, usually once a year, that the interest rate is reset on an adjustable-rate mortgage.
Annual percentage rate (APR): The real cost that you pay to borrow, stated as a yearly percentage of the loan amount. This is sometimes called your effective borrowing cost. For auto and mortgage loans, closing costs and discount points are added to calculate APR. For example, if you pay $500 in closing costs to obtain a $10,000 loan, the APR will be higher than the interest rate since you are effectively borrowing $9,500 but will owe $10,000. The Truth-in-Lending Act requires the lender to disclose the APR to you. For credit cards, the annual fee is often not included in the APR calculation. As a result, an APR of a credit card is often its simple interest rate.
Appraisal value: Appraisal value is the market value of an asset that is derived from the appraisal process. Depending on the asset, the method used to appraise the asset will differ. For homes, appraisers often use a method that includes recent sales data of comparable homes. They may also use the replacement method, which is the cost to replace the home at today's prices.
Appreciation rate: Appreciation rate is the yearly percentage rate that an asset increases in value. For example, a home that you paid $150,000 three years ago that is almost worth $200,000 today had an average appreciation rate of 10%. After the first year, the home was worth $165,000. After the second year, the home was worth $181,500. And after the third year, the home is worth just a little under $200,000.
Base rate: The interest rate that is used as a benchmark to set the interest rate for borrowers. A base rate is sometimes called an index rate. For example, if you obtain a one-year adjustable-rate mortgage, your loan rate will be reset once a year to a rate that equals the loan rate plus a margin. Interest rates on credit cards are frequently tied to a change in the prime rate, another popular base rate used in consumer lending.
Break-even point: When you refinance a mortgage, the decision is profitable if you are able to pass the break-even point. At the break-even point, the savings you receive from refinancing equal the costs. A common break-even analysis is to calculate how long you must live in a home after you refinance in order to recover the closing costs you paid to refinance. For investing in stocks and mutual funds, break-even analysis is used to calculate the minimum sale price that allows the buyer to recover the transaction costs from buying the shares. For business operations, a business reaches its break-even point when it generates enough sales to pay for all its fixed costs. For each additional dollar of sales, variable costs should be less than a dollar. As a result, each dollar of sales past the break-even point generates some profit.
Closing: Closing is the final stage of the loan process that requires an exchange of any funds due the other party and any signatures for recording the transaction. Closing costs are paid at the closing.
Closing costs: Closing costs are the total expenses that the buyer pays at the time a real estate transaction is completed. This stage of the transaction is called "closing." Closing costs include application, underwriting and loan-origination fees; mortgage points; title search and insurance; fees for related legal services; and costs to fund an escrow account. For home mortgage loans, closing costs generally range between 3 and 6 percent of the home purchase price.
Conservative qualification estimate: Mortgage lenders are more conservative when the economy is weak. As a result, they tend to raise their loan-qualification requirements to make it more difficult to qualify for loan.
Cost-benefit analysis: For autos: an analysis that compares the cheaper of a) borrowing money to buy a car and paying the interest, with b), paying cash for a car, and losing the opportunity to earn a rate of return on the savings applied to the purchase. For homes: an analysis that subtracts the benefits of homeownership from the costs of homeownership to obtain a net cost. Included in costs are mortgage interest, discount points, closing costs, property taxes and homeowners insurance, home maintenance costs, and any private mortgage insurance (PMI). Included in benefits are the tax savings on deductions for mortgage interest (including points) and property taxes, and an increase in equity that you receive either from repayment of the loan principal or an appreciation in the value of your home.
Cost-of-funds index (COFI): The 11th District Monthly Weighted Average Cost of Funds Index (COFI) is one of many indexes used by mortgage lenders to adjust the interest rate on adjustable-rate mortgages (ARMs). COFI reflects the actual interest expenses recognized during a given month by all savings-institution members of the Federal Home Loan Bank of San Francisco (Source: FHLB of San Francisco).
Debt ratio: Lenders use a debt ratio (also called debt-income ratio) to approve loan applicants. Debt ratio equals combined monthly debt payments divided by gross monthly income. For example, combined monthly debt payments of $2,000 divided by gross monthly income of $4,000 equals a debt ratio of 50%.
Down payment: A down payment is the cash you deposit towards the purchase of a home, business property, or vehicle. The larger the down payment, the less you need to borrow. For home loans, a down payment of 20% of the home purchase price is generally required to avoid private mortgage insurance. The value of a trade-in vehicle is often used instead of a down payment for purchasing a vehicle.
Effective interest rate: The effective interest rate is your true interest-rate cost of borrowing stated as an annual rate. It may be shown on an after-tax basis, adjusting for a mortgage interest deduction. The effective rate on a mortgage or consumer loan includes fees, points and other charges that you pay when you close the loan. The effective rate also includes compounded interest. Higher closing costs or more frequent compounding result in a higher effective interest rate.
Fees: Fees include mortgage points and expenses to underwrite and originate a mortgage loan. One point equals 1% of the loan amount. The IRS considers points to be a form of prepaid interest. Expenses include fees for appraisal, title search, recordation of documents, and conveyance taxes. Total closing costs include these fees, prepaid interest to the first mortgage payment, and prepayments for homeowners insurance and property taxes.
Equity: Real estate: the residual ownership claim on a home's value. Equity equals the fair market value of a home, less any mortgage debt or other obligations. Stocks or businesses: an ownership stake in a company. Shareholders equity is equal to assets minus liabilities.
Homeowners insurance: Also called property insurance, homeowners insurance protects the homeowner from weather-related damage, as well as potential liability from events that occur on the property. Lenders require homeowners insurance coverage to protect the collateral that secures their loan. Some homeowners insurance policies do not cover catastrophic events such as tornadoes, hurricanes or floods. These kinds of events generally require a separate insurance policy.
Homeowners Protection Act: The Homeowners Protection Act of 1999 requires home lenders to cancel a requirement for private mortgage insurance (PMI) if the borrower has equity of at least 22% in their home. (This is equal to a loan-to-value ratio of below 78%.) The law allows the borrower to request dropping PMI when equity reaches 20% of home value. A current appraisal may be required to ascertain the home value. For more information, see the Web site of the U.S. Dept. of Housing and Urban Development.
Housing ratio: Lenders use housing ratio to approve loan applicants. Housing ratio equals combined monthly mortgage payment divided by gross monthly income. For example, a combined monthly mortgage payment of $1,500 divided by gross monthly income of $4,500 equals a housing ratio of 33%.
Impounds for taxes and insurance: Impounds are payments that you make in advance for homeowner's insurance premiums and real estate taxes. You make these payments to an escrow account at loan closing, and periodically replenish the account. An escrow agent pays the local tax authority and insurer from this account. Analyzers calculate impounds for two months. Local lending requirements on funding the escrow account vary.
Income tax rates: The Jobs and Growth Tax Relief Reconciliation Act of 2003 cuts individual income tax rates for all brackets except the 10% and 15% brackets. The 10% tax bracket covers the first $7,000 of income for single taxpayers, $10,000 for single parents, and $14,000 for married taxpayers. As a result of the 2003 Tax Act, tax rates for 2003 are 10%, 15%, 25%, 28%, 33%, and 35%.
Index rate: An index rate is a widely used interest rate that lenders use to set the interest rate on loans and credit cards. For residential mortgages, 10-year U.S. Treasury securities are often used for 30-year fixed-rate loans (on average, most homeowners live in their homes for a period of time closer to 10 years than 30 years). For ARM loans, a common index is the Eleventh District Cost of Funds Index (COFI), published by the San Francisco-based district office of the Federal Home Loan Bank. For credit cards, the U.S. commercial prime rate is frequently used as an index rate.
Initial interest rate: The starting interest rate on an adjustable-rate mortgage loan, which is often below market ARM rates. The intent of a low initial rate is to assist homebuyers that may not otherwise qualify for a mortgage loan.
Interest-only payments: Mortgage payments that include only interest. No loan amortization occurs and, thus, the homeowner does not accrue any equity (unless the home value increases).
Interest rate cap: A limit on the amount the interest rate can increase. A periodic cap limits how much the rate can increase at each adjustment period. A lifetime cap limits how much the rate can increase during the term of the loan.
Lifetime cap: A lifetime cap is the limit to how much the interest rate on an adjustable-rate loan can be increased over the term of the loan.
Loan-to-value (LTV) ratio: Homes: Loan-to-value ratio is a key factor in determining how much of a home you can qualify for. To calculate, divide the mortgage loan amount by the fair market of the home value. A recent appraisal is generally required to determine fair market value. If you have existing mortgage debt or are adding debt, divide the combined mortgage balance by the home value. For example, a mortgage loan of $150,000 on a home that is appraised at $200,000 has an LTV of 75%. As a general rule, mortgage loans that exceed an LTV of 80% require private mortgage insurance.
Loan qualification estimates: aggressive versus conservative: Lenders ease their loan-underwriting guides when economic times are good. This environment leads to more competition among lenders for qualified borrowers. Thus, lenders become more aggressive in making loans. When economic times are worse, lenders rein the amounts they are willing to lend. Thus, lenders become more conservative.
Margin: Margin has different meanings for different industries. For mortgage lending, margin is the amount a lender adds to the base rate of an adjustable-rate mortgage or other variable-rate loan to set the loan rate. For example, if a one-year ARM loan has a margin of 300 basis points over the yield on 1-year Treasury bills and the T-bill yield is 6.5%, the loan rate is set to 9.5%. For brokerage accounts, margin is the deposit required by an investor who short-sells a stock (i.e., borrows shares from a broker and sells the shares, hoping to buy them back at a lower price and return the borrowed shares.)
Mortgage interest deduction: The mortgage interest tax deduction allows you to deduct the mortgage interest expense you pay on mortgage and home equity debt, up to certain limits of debt. The deduction lowers your tax bill by an amount equal to the amount of interest times your tax rate. To take the mortgage interest deduction, you must itemize the deduction using Schedule A of IRS Form 1040.
Mortgage points: Mortage points are also called discount points, points, loan discount points, loan origination fees or maximum loan charges. A point is equal to 1 percent of the loan amount. For example, 1 point on a loan of $150,000 equals $1,500. Lenders consider mortgage points as interest that you pay in advance. As a result, the more points you pay when you close the loan, the lower your interest rate. If you qualify, you may be able to deduct mortgage points in the year you close the loan for tax purposes. Otherwise, you will have to amortize the points paid over the term of the loan.
Negative amortization: This is a phenomenon in home lending which occurs when a payment cap restricts the repayment to an amount less than the payment necessary to reduce the principal balance. This has the effect of increasing the loan amount.
Origination fee: A lender may charge an origination fee that is additional to any mortgage points you pay. Origination fees are the lender's charge for funding your mortgage with a mortgage broker. The process of funding your loan is called origination.
P+I: P+I is an acronym for loan principal and interest that you pay on an amortizing loan, including mortgage loans. If your mortgage loan payments include property taxes and homeowner's insurance, the monthly payment amount is referred to as P+I+T+I.
P+I+T+I: P+I+T+I is an acronym for loan principal, interest, property taxes and homeowner's insurance.
Payment cap: A limit on the amount that the monthly payment can increase. A periodic cap limits the amount of the increase at each adjustment period. A lifetime cap limits the amount that the monthly payment can increase during the term of the loan. A potential peril of payment caps is negative amortization. In the case of an adjustable-rate mortgage with a payment cap, rising interest rates may cause the loan payment to be insufficient to cover even the interest portion of the scheduled payment. In this case, the unpaid interest may be added to the mortgage loan principal, if the loan agreement permits.
Periodic rate cap: The periodic interest rate cap is the maximum amount the loan rate can change on an adjustable-rate mortgage loan on the anniversary date. ARM loan rates are often reset once a year after an initial period. A lifetime cap often exists. A lifetime cap limits the maximum loan rate that can be charged.
Prepayment: A prepayment is an amount that you pay on your mortgage or other loan that constitutes an additional, unscheduled payment. Prepayments pay off a loan sooner and reduce total interest expense.
Prepayment penalty: A prepayment penalty is a penalty that a lender may charge if you make unscheduled, extra payments on your loan.
Principal: Principal is either the original amount of your investment or loan. In the case of an investment, principal is also called your investment capital. In the case of a loan, principal is also called the loan balance.
Prepaid interest: Prepaid interest is the interest that you pay the lender in advance, often when you close on a loan. If you close a loan before the end of the month, the lender will require you to pay interest for the number of days until the end of the month. This is one form of prepaid interest. Analyzers that calculate prepaid interest assume the loan closing date is the midpoint of a 30-day month. As a result, prepaid interest is calculated for 15 days. The IRS recognizes points that you pay at loan closing as prepaid interest. One point equals 1% of the loan amount. If you meet a checklist of requirements, the IRS allows you to deduct these points in the first year of your mortgage loan.
Private mortgage insurance (PMI): Private mortgage insurance is an insurance policy that a residential mortgage lender requires of the borrower if the loan-to-value (LTV) ratio of the home is greater than 80%. Mortgage insurance protects the lender from the risk that the borrower may default on the loan. Federal law requires lenders to notify borrowers when the loan-to-value ratio drops below 80%. Mortgage insurance premiums vary, but generally range from $1,000 to $5,000 a year for an average priced home.
Property taxes: Property taxes are also called real estate taxes. These taxes are paid to the local taxing authority or municipality. The amount you pay can generally be deducted from your federal income taxes. Property taxes are often levied as a percentage of your home's assessed value. For example, if you pay 0.5% in property taxes of the assessed value, a home assessed at $250,000 would have a yearly property tax bill of $1,250.
Refinancing: Refinancing is a means of replacing high-interest debt with a loan that has a lower interest rate. But it can also be done in order to switch from a fixed to variable rate, or vice versa, or to eliminate a balloon payment. A cash-out refinancing is one that involves you paying off your loan and borrowing an additional amount. The entire loan amount is secured by a mortgage lien on your home.
Savings interest rate: The savings interest rate is the yearly interest rate you earn on your savings. It is also used to calculate the opportunity cost of paying with cash. In contrast, the saving rate is the percentage of income you save.
Tax-deductible: A tax-deductible expense or contribution reduces your taxable income. To calculate the worth of a tax deduction, multiply the deduction by your income tax rate. For example, if you deduct $10,000 in mortgage interest expense and are in the 25% income-tax bracket, the tax deduction is worth $2,500. If you deduct $1,000 in contributions to a charity, the tax deduction is worth $250.
Tax savings: Tax savings are the amount you may save in taxes from a tax deduction or credit that you would otherwise pay if you did not have the deduction or credit. Tax savings are also called a tax shield. To calculate tax savings from a deduction, multiply the amount of the deduction by your marginal income tax rate. At an income tax rate of 25%, a $2,000 qualified contribution to a company retirement plan may save you $500 in taxes. And if you paid $10,000 in home mortgage interest, you may save up to $2,500 in income taxes if you are in the same tax bracket. Your deduction for interest expense on mortgage and home equity debt may be limited. You may wish to consult a financial or tax adviser. For businesses, tax savings are realized on such deductible expenses as lease payments, interest on loan payments, and depreciation expense.
Tax shield: Tax shield is the amount of taxes you may save from a tax deduction or tax credit that you would otherwise pay without the deduction or credit. To calculate tax savings from a deduction, multiply the amount of the deduction by your marginal income tax rate. At a marginal income tax rate of 25%, a $2,000 qualified contribution to a company retirement plan may save you $500 in taxes. And if you paid $10,000 in home mortgage interest, you may save up to $2,500 in income taxes if you are in the same tax bracket. Your deduction for interest expense on mortgage and home equity debt may be limited. You may wish to consult a financial or tax adviser. For businesses, tax savings are realized on such deductible expenses as lease payments, interest on loan payments, and depreciation expense.
Term: The period of a loan, generally measured in years. Auto loans: generally range between two and five years. Mortgage loans: generally 15 or 30 years.
Treasury bill: U.S. Treasury bills are short-term debt obligations of the U.S. Treasury. T-bills are usually issued to mature in three or six months. Prices for T-bills are stated as a discount to the par value. For example, a T-bill with a price of 99.65 is selling for 99.65% of its par value. T-bills are auctioned weekly and used to pay operations of the federal government. T-bills are considered to be among the safest and most liquid investments.

Underwriting: Underwriting means different things to different financial-services industries. For mortgage lenders, it is the process of evaluating a loan prospect to see if they have the financial capacity to repay the loan. For investment bankers, it is the process of arranging a sale of stocks or bonds to investors. For insurance companies, it is the process of calculating a premium for a specific pool of insurees with certain risk characteristics such as age or health.
Yield: Yield is used to measure the investment performance of a security. For mutual funds, yield is generally measured as dividends as a percentage of the price of a fund share. For bonds, yield is often calculated in one or more of three major ways: current yield, yield-to-maturity and yield-to-call. Current yield is the bond coupon rate divided by current price. It is an expedient but incomplete method for calculating yield. Yield-to-maturity (YTM) is the expected yield an investor earns for holding a bond to maturity. YTM includes coupon income and any premium or discount the investor pays. Yield-to-call is the expected yield an investor earns if the bond is held until its first call date, when it is assumed to be called by the company that issued the bonds. Difference in bond yields is called the yield spread or credit spread. Yield spread measures the extra yield a bond must pay to compensate for additional risk over a risk-free bond. For example, if a 10-year corporate bond earns a yield of 6.25% and a 10-year U.S. Treasury bond yields 5.75%, the yield spread is 50 basis points.

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