Memo to First Time Buyers: How to Avoid Closing Cost Sticker Shock
After all that hard work to get there, that's what a first-time buyer should be doing at the closing. Unfortunately, it's often not the case. Somehow all those closing costs seem much larger than expected. If you listen closely, you can hear the buyer thinking: "Were all those costs properly explained to me at the beginning of the transaction?" But a better result is possible.
The Deer in the Headlights Syndrome
It never ceases to amaze me how little first-time buyers know about purchasing a home. All the blogs, resource websites and reality TV shows notwithstanding, it's just plain difficult for a beginner to digest all the facets of a real estate transaction, particularly the costs associated with a closing. Here's the typical mindset for some first timers: the purchase price, less the gross amount of the mortgage loan, equals the out-of-pocket exposure. Although buyers should be disabused of this notion as soon as possible, that just doesn't happen as regularly as it should. There are a number of costs that must be identified and explained upfront, but there are two areas that are particularly troublesome: title charges and loan expenses.
Being at Peace with Title Charges
Condo or home buyers soon learn that there is an important player at the closing table: the title closer representing the "title company." There may be a few brave souls who purchase real estate without obtaining a title insurance policy, but for almost all buyers, obtaining title insurance is part and parcel of purchasing a home. If a bank is lending money, there is no choice -- the purchaser must obtain title insurance for the benefit of the lender. Title insurance, in theory, protects a buyer from third parties who may claim an interest in the property or who may have a lien against it, such as a bank or other creditor.
How it Works
In order to facilitate the process, soon after the contract is signed, the title company, at the behest of the buyer's attorney, searches the title and prepares a report of possible "exceptions" or "objections" that must be "cleared" by the seller before closing. If the title company fails to discover a valid lien against the property and insures the title free of such encumbrance, the buyer would be protected down the road against a claim made by the party asserting an interest in the real estate. Whether the title company will be allergic to paying a claim arising under insured title, is a conversation for another time. Here's the bottom line of the title insurance process: although a closing can't take place without it, title insurance is expensive.
What Are We Talking About?
Let's take a somewhat typical purchase scenario: a $750,000.00 condo, where the buyer is obtaining eighty percent financing (that is, a $600,000.00 mortgage loan). When you add up the mortgage insurance premiums for the buyer and the bank, the various searches, mortgage recording tax (a substantial fee in New York for recording a mortgage that varies by county throughout the state), charges for recording the deed and other related documents, the title bill will add more than $16,000.00 to the buyer's closing costs. For most first-time buyers, who have no clue that such an enormous expense is in the pipeline, we're talking about real money. It is essential, therefore, that the title company prepare an estimated title bill as soon as the title order is placed, so that the buyer has sufficient time to adjust his or her expectations of the funds needed for closing.
What About Co-ops?
Although a version of title insurance is available for co-ops, in the form of "leasehold insurance," in most cases, only a lien search will be undertaken at a modest cost (approximately $300). Not a big. But both co-ops and condo buyers have to contend with one additional significant expense generator in common: the bank.
The Loan Expense Disconnect
Due to changes in banking law, a buyer must receive a "good faith estimate" of closing expenses within three business days after the submission of the loan application. This document has become incredibly cumbersome, with potential deal threatening consequences when there are material cost understatement errors on the disclosure form. Although banking reform intended the changes to the "GFE" to inform and protect the consumer, it's questionable at this point whether the presentation of closing costs on the form confuses rather than helps. More than anything else, however, first-time buyers often do not appreciate the obvious: that those loan expenses itemized on the good faith estimate will be deducted from the gross amount of the loan proceeds at closing. That $600,000.00 loan referred to above, could yield "net proceeds" of as little as $590,000.00, or even less, depending upon a number of factors. How could that happen?
Adding up the Costs of Lending
There are a number of standard loan expenses that are paid out of proceeds: origination fees, if any (which could total up to three percent of the face amount of the loan), interest for the month in which the closing occurs, soft costs often called "underwriting expenses" or "document preparation" fees, appraisal or other application costs not paid in advance, the legal fee of the bank attorney, mortgage insurance (if required), escrows for real estate taxes and insurance (for condos, but not co-ops) and various other goodies such as flood zone and tax certifications. When you subtract these expenses from the gross loan amount, its takes a toll on the funds that the buyer will actually receive at closing. Mortgage brokers and loan officers dutifully complete and deliver the GFE to the newbie buyer to comply with tighter lending requirements. It's unclear to me, however, whether sufficient time is taken to explain the numbers contained in that document and the most important reality of getting a loan -- it costs money to borrow money.
Residential Reality: Crunch the Numbers Early and Often
A first time buyer has a lot on his or her plate once the offer is accepted. In addition to pre-contract due diligence, negotiating the contract and navigating the increasingly complicated loan process, getting a grip on closing costs is always a challenge. Making sure that the buyer understands the expected out-of-pocket expenditures in addition to balance due on the purchase price is the sine qua non of a successful transaction and a happy buyer. So here's a good rule to remember for both the buyer and the professionals involved: when it comes to explaining closing costs to the first-time buyer: once is not enough...
For more about closing costs, see "The Skinny on Closing Costs".