Who Pays Whose Closing Costs?

"No buyer in their right mind pays their own closing costs. The seller will do that."

That's what one of my buyers was recently told at a "first time homebuyers seminar." It didn't strike me as particularly useful information. But it did make me realize that a lot of buyers don't fully understand the concept of "closing costs", whose costs are whose, what those costs go toward, and who's responsible for paying them.

I think a lot of buyers lump all "closing costs" into the category of "what it costs to close the deal", figure those costs are all mutually incurred, and thus each party equally benefitting. Under that scenario, one party is as responsible as the other, and who pays what is strictly a matter of negotiation.

But that's not the case. In Colorado, the only real expense that truly benefits both parties equally is the 200 bucks or so that the title company is paid to close the transaction. That fee is usually split between the buyer and seller. In addition there are some nominal recording and transaction fees required by the various municipalities for the privilege of recording the transaction. These fees are very, very small as an overall percentage of the total closing costs.

So when a buyer pays thousands of dollars in closing costs, what are they paying for? The vast majority of that money is paid to the buyer's lender for the buyer's loan. Here's a rough overview of how it breaks down:

Origination fee: Most lenders charge an origination fee of 1% of the loan amount. That's a lot of money -- $1000 for every $100,000 borrowed.

Points: Some buyers choose to pay additional "points" (usually 1% of the loan amount for every point) to buy down their interest rate.

Title Insurance: The lender doesn't want to get stuck with a loan on a house that the buyer doesn't rightfully own.

Appraisal: Because the property is the collateral on the loan, the lender will take it back if the buyer fails to make payments on the loan. The lender therefore has a vested interest in making sure that the house is worth what they're paying, and so they require an appraisal of the property to. Does the lender pay for that? Of course not -- the buyer does!!

Days of Interest: Most buyers are delighted to find out that they won't have to make their first house payment until the first day of the second month after closing. In other words, if the purchase closes in June, they won't have to make their first house payment until August 1st. There's a reason for that. Mortgage payments are made "in arrears", which means you're always paying for the previous month. An August 1st payment is paying the July interest expense. But where did June's interest go? It's collected at closing, when the buyer pays the interest on their loan for the rest of the month. If the loan closes early in the month, that can be equal to almost an entire month's loan payment.

Escrow: Most buyers set up their loans to take a certain amount every month for property taxes and insurance. Their lender will then require that the buyer set up a reserve in advance (ie at closing) so that those escrow accounts start out with a positive balance.

Fees, fees, fees: Processing fees and handling fees and overnight shipping fees, blah, blah, blah. If the lender incurs an expense along the way, it's passed on the the buyer.

All of these fees are the buyer's expenses. They benefit the buyer, and paying them is the buyer's responsibility.

Sometimes buyers, especially first-time buyers, don't have the thousands and thousands of dollars on hand that they need to close their loans. So, as a part of their offer, they ask the sellers to pay a certain amount toward their closing costs. Sellers will often agree to this because they realize it's the only way this particular buyer could buy the house. But they mentally subtract that amount from their net proceeds, and negotiate the price accordingly. In other words, if they're agreeing to pay $4000 in closing costs, they're going to ask for $4000 more in the purchase price than they would have if they weren't paying closing costs. Because essentially it's money they're giving to the buyer to pay costs that are the buyer's responsibility and for the buyer's benefit.

Remember, the sellers have their own closing costs, and they're generally much more than the buyer's costs. Seller pays:

Agent commissions: The seller pays both real estate agents. Yes, the seller generally pays anywhere from 5% to 7% of the purchase price of the home for commission, including 2.8% that goes to the buyer's real estate agent. That's a pretty good deal for the buyer!

Title Insurance: This is purchased for the sake of the buyers, to assure them that that they're not ending up paying for a home they don't legally own.

Property Taxes: The seller pays the buyer for whatever property taxes are owed for the days of the year the seller lived in the house. (The buyer will turn around and give that money to the county when the tax bill comes!)

HOA Transfer Fees: Oddly, this can add up to lots of hundreds of dollars. HOA management companies often charge into the three figures just to write a letter.

So will the seller pay the buyer's closing costs? That depends on a lot of factors. How long has the house been on the market? How "motivated" (anxious, desperate) is the seller? Can the seller make up enough in the purchase price to justify the money they're giving back in the form of closing costs?

Sometimes asking the seller to pay for closing costs is the right thing to do. But just know that "it all comes out in the wash." Purchase price or closing costs, sellers are going to be looking at their bottom line, and negotiating accordingly.