The real estate industry has done a bang-up job of letting consumers know they’ll need some cash when they purchase a home. Typically, it’s the down payment that’s mentioned. Seldom are closing costs brought up and even when they are, it’s usually in rough, “estimated” numbers. End result: buyers can end up with a major surprise at the closing table.
Here’s a more detailed breakdown of how these two chunks of money – down payment and closing costs – are paid prior to and at the closing of your home purchase.
Earnest Money Deposit
You found the home you want to buy and you and your agent structured the perfect purchase agreement. In it, you’ll find a section dealing with your earnest money deposit (EMD). Your agent will list the amount you are paying and where it will be held.
So, what is this? There are several functions of an earnest money deposit. First, it shows the seller that you are serious about pursuing the purchase. After all, he or she will be taking the home off the market. This “skin in the game” evens the playing field. The seller takes a gamble by removing the home from the market and you put your cash on the line with the possibility of losing it if you renege on your contractual obligations.
The amount of money used for your EMD varies according to several factors, including what type of market you’re in (in hot, seller markets, a larger-than-normal EMD may entice the seller to choose your offer).
Typically, it’s 2 to 5 percent of the offered price. In the first half of 2020, the median home sale price in Montgomery County, PA was $319,500. That translates to an earnest money deposit of between $6,390 and $15,975.
Down payments are usually expressed as a percentage of the purchase price of the home. For example, using our Montgomery County, PA median home price of $319,500, you will need $63,900 for a 20 percent down payment, $31,950 for a 10 percent down payment and $11,183 for a 3.5 percent down payment.
Down payment percentages depend upon the loan you’ll be obtaining. Conventional loans generally require a minimum of 5 percent down and at least 20 percent down in order to avoid paying a monthly private insurance premium.
This is the part of the process that can catch homebuyers by surprise. Closing costs are all the fees required of everyone who helps you purchase the home. From real estate broker service fees and an appraiser’s fee to the title company’s research and issuance of a policy and, of course, the lender’s fees. These fees add up – fast – so it’s important to compare closing cost estimates from several lenders. It’s also important to understand which costs are negotiable.
It’s not unusual for closing costs to amount to 2 to 5 percent of the loan amount. Using the median home price mentioned above, with a 3.5 percent down payment ($11,183), the loan amount will be about $308,317. Closing costs would be anywhere from $6,166 to $15,416. As you can see, it’s important to know these numbers early on in your home buying process.
3 Ways to reduce closing costs
1. You can reduce a portion of your closing costs by closing as late in the month as possible. Lenders charge interest in arrears, meaning that when you make a house payment, you are actually paying for last month’s interest (and the coming month’s principal). When you close escrow, the lender will have calculated how much interest you owe from the date your loan was funded to the end of the current month.
For example, if you close on your new home on August 15, you’ll pre-pay the interest due from August 15 until August 31. September’s interest isn’t due until October 1, when you will make your first house payment.
Reduce the pre-paid interest charge by closing near the end of the month.
2. You can eliminate the need to pay all or part of your closing costs by requesting in your offer that the seller contribute, from their proceeds, some amount toward your costs. This is a common mortgage technique but you may need to bump up your offer price to entice the seller to agree to this.
3. Ask your lender if you can include the closing costs in your loan amount. Yes, there will be a charge for this and yes, it means your monthly payment will be a bit higher. But you’ll minimize the immediate outlay of cash necessary to pay closing costs and close on your home purchase.
Despite what many first-time homebuyers think, the down payment isn’t the whole ball of wax when it comes to cash outlays when you purchase a home. It’s important to determine exactly how much cash you’ll need to purchase a home so that you can budget for these expenses.
The author, Rick Sheppard, is a licensed real estate broker with RE/MAX Achievers, Inc in Pennsylvania and a 32+ year veteran of the real estate trenches. He knows a lot because he’s seen a lot. If you have any questions about this or any real estate related topic, feel free to contact Rick at [email protected] and he’ll do his best to answer your questions.