Closing Costs vs Down Payment

Introduction

When it comes to buying a home, there are various financial implications of Closing Costs vs Down Payment. While they are paid at closing, they serve different purposes and have distinct implications for buyers.

In this blog post, we will define closing costs vs down payment. We will also explore the similarities and differences between down payments and closing costs.

The question of Closing Costs vs Down Payment is one that comes up often. Especially amongst first-time home buyers. Many first-time homebuyers are not familiar with the intricacies of the home buying process. And it is common for people to confuse down payments and closing costs.

Closing costs are however separate from down payments. Lenders provide detailed breakdown of closing costs vs down payment during the loan application process.

Definition of Closing Costs vs Down Payment

Closing costs refer to the fees and expenses that are associated with the purchase of a home. They are due at the time of closing. These costs can vary widely but typically include expenses such as appraisal fees, title insurance, loan origination fees, and attorney fees.

A down payment on a house is an upfront, out-of-pocket amount that is separate from the mortgage loan. The down payment represents the buyer’s financial investment in the home and serves as a form of collateral.

The size of the down payment is usually stated as a percentage of the total purchase price. It is typically paid at the closing of the transaction. It varies based on factors such as the loan program, lender requirements, and the buyer’s financial situation.

FAQs:

Are closing costs part of down payment? No.

Are closing costs separate from down payment? Yes

Is down payment included in closing costs? No.

Similarities

While down payments are different from closing costs, they do share some similarities.

• Both are typically paid upfront at closing. Paid via personal checks, wire transfers, or certified funds.
• They can significantly impact the overall cost of purchasing a home and influence the buyer’s budget and financial planning.
• The actual amounts of both closing costs and down payments can vary depending on several factors. These factors include the purchase price of the home, the specific mortgage program or loan type, location, and individual circumstances.
• Lenders assess a buyer’s ability to cover both closing costs vs down payment when evaluating their finances.

Differences

There are several differences between down payment and closing costs.

A. LTV Ratio Effect of Closing Costs Vs. Down Payment

LTV stands for Loan to Value. Down payments affect the loan to value ratio. Closing costs, typically do not affect the loan to value ratio.

Loan to value ratio is the ratio of the home loan amount to the appraised value of the property.

On Down Payments

The higher the down payment, the lower the LTV ratio. The lower the down payment, the lower the LTV.

To make this real, let’s consider an example where Buyer A and Buyer B are purchasing a $600,000 house.

Buyer A:

• Purchase Price: $600,000
• Down Payment: $120,000 (20% of $600,000)
• Loan Amount: $480,000
• LTV Ratio: ($480,000 / $600,000) * 100 = 80%

Buyer B:

• Purchase Price: $600,000
• Down Payment: $60,000 (10% of $600,000)
• Loan Amount: $540,000
• LTV Ratio: ($540,000 / $600,000) * 100 = 90%

In this example, Buyer A makes a 20% down payment, which amounts to $120,000, and obtains a loan of $480,000. The down payment reduces the loan amount, resulting in an LTV ratio of 80%. This means Buyer A is borrowing 80% of the property’s value and has a 20% equity stake.

Buyer B, on the other hand, makes a 10% down payment, which amounts to $60,000, and obtains a loan of $540,000. With a smaller down payment, Buyer B has a higher loan amount and an LTV ratio of 90%. This means Buyer B is borrowing 90% of the property’s value and has a 10% equity stake.

Lenders view lower LTV ratios as less risky compared to higher LTV ratios. This can impact loan terms, such as interest rates and the requirement for private mortgage insurance (PMI).

On Closing Costs

Closing costs typically do not directly affect the loan-to-value (LTV) ratio. Closing costs are expenses incurred during the home buying process that are separate from the loan amount. Since closing costs are not part of the loan amount, they do not affect the calculation of the LTV ratio.

I should however note that closing costs do indirectly affect the amount of funds needed to complete the purchase transaction. Higher closing costs mean that the buyer will need to bring additional funds to the closing table beyond the loan amount. A higher closing cost might mean the buyer now has funds available for the down payment and vice versa.

Having said that, rolling closing costs into the loan will have a direct impact on the LTV ratio. Still, only a portion (not all) of closing costs can be rolled into a loan. And whatever isn’t rolled will not impact the LTV ratio.

B. Financing of Closing Costs vs Down Payment

Lenders prohibit home buyers from financing the down payment for a house. Depending on the lender, home buyers can finance closing costs.

To finance something is to borrow money from a lender to cover the cost of that thing.

On Down Payments

Lenders often allow borrowers to use “gift funds” for the down payment. A gift is when a family member or close relative provides funds to the borrower with no expectation of repayment. Gift funds can be used to supplement the borrower’s own funds for the down payment.

To ensure that the down payment is not a loan disguised as a gift, they typically require:

• Gift Letter: Most lenders require a gift letter. It is a document signed by the gift donor stating that the funds are a genuine gift and not a loan.
• Documentation: Lenders typically require proper documentation to track the transfer of gift funds. This may include bank statements or other evidence showing the source of the funds and their transfer to the borrower’s account.
• Familial Relationship: Lenders may have specific guidelines on who can provide gift funds. They usually allow gifts from immediate family members, such as parents, grandparents, siblings, and sometimes close relatives. Gifts from friends or unrelated individuals may not be accepted.

On Financing Closing Costs

To finance a closing cost is to roll a portion (or all) of the closing costs into the mortgage loan amount. A home buyer’s ability to finance closing costs will depend on lender guidelines. A lender’s decision to include closing costs in a mortgage loan will depend on the buyer’s:

• Loan to value ratio
• Creditworthiness
• Debt-to-income (DTI) ratio
• Other factors.

It’s important to weigh the benefits of financing closing costs against the long-term costs. Financing closing costs can provide upfront relief by reducing immediate out-of-pocket expenses. It may however result in higher overall borrowing costs.

C. Lower Limit of Closing Costs vs Down Payment

Houses can be bought with no down payment ($0). Houses cannot be bought without incurring closing costs. This is because closing costs are incurred due to the house purchase. These costs include things like:

1. Loan Origination Fee
2. Title Search Fee
3. Title Insurance Fee
4. Underwriting Fee

No lender worth its salt will provide a buyer with a mortgage without conducting a title search. Any lender will want to protect its financial interest in the property. And title searches aren’t t free.

Activities—like title search—result in closing fees. These closing activities cannot be eliminated. Therefore, closing costs cannot be eliminated and therefore cannot be $0.

Buyers should however carefully consider the financial implications of allocating more funds towards closing costs vs down payment.

D. Tax Deductibility Factor of Closing Costs vs Down Payment

Down payments are considered a personal expense and are not eligible for tax deductions. On the other hand, certain closing costs may be tax-deductible.

Closing Costs Generally Non-Deductible for Tax Purposes

• Many closing costs, such as appraisal fees, title fees, and inspection fees, are typically not tax-deductible. These costs are considered personal expenses related to the purchase or sale of a property.

Closing Costs Potentially Deductible for Tax Purposes:

• Mortgage Interest: The interest paid on a mortgage loan for a primary residence, or a second home may be tax-deductible.
• Points: Points paid as part of obtaining a mortgage loan may be deductible. Each point is equal to 1% of the loan amount. Deductibility depends on factors such as the purpose of the loan and the use of the funds.
• Property Taxes: Property taxes paid at closing may be deductible as an itemized deduction on your federal income tax return.

E. Shopping Around for Closing Costs vs Down Payment

A home buyer cannot shop around for a down payment. However, a home buyer can shop around for closing costs.

In real estate, “shopping around” refers to the process of exploring different options and comparing prices.

In real estate, a home buyer can shop around for:

• A property: When looking to buy or rent a property, shopping around involves exploring different listings, visiting open houses, and considering various neighborhoods or locations. It allows you to compare different properties in terms of size, features, amenities, pricing, and suitability for your specific requirements.
• A Mortgage Lender: Shopping around for a mortgage involves researching and comparing offers from different lenders. This includes reviewing interest rates, loan terms, fees, and eligibility criteria. By obtaining quotes or pre-approvals from multiple lenders, you can assess the best available options and potentially negotiate better terms.
• A Real Estate Agent: This involves interviewing and meeting with multiple agents to ensure a good fit.
• Service Providers

On Down Payments

A home buyer is responsible for providing the down payment from their own funds or other eligible sources.

While a home buyer can explore different options for saving or accumulating the necessary funds for the down payment, they cannot actively shop around for different down payment amounts or negotiate the down payment requirement with different lenders or sellers. The down payment requirement is determined by the loan program, lender guidelines, and the terms agreed upon during the home purchase negotiation.

What a buyer can do is explore different loan programs that offer varying down payment options. For example, some loan programs, like FHA loans or VA loans, offer lower down payment requirements compared to conventional loans. Understanding the role of loan programs and eligibility requirements is crucial in determining how the buyer’s financial situation impacts closing costs vs down payment.

On Closing Costs

To shop around for closing costs means to explore and compare different options and service providers to potentially obtain more favorable terms and pricing for the fees and expenses associated with the home buying process. Shopping around allows buyers to seek competitive rates and potentially save money on closing costs.

Buyers should review the Loan Estimate provided by the lender to understand the breakdown of closing costs vs down payment requirements.

F. Seller Contribution Towards Closing Costs vs Down Payment

Seller contributions go towards closing costs vs down payment.

Sellers cannot contribute towards a buyer’s closing costs. When I closed on my house, my seller contributed a four-figure amount towards my closing costs.

Seller contributions are also known as seller concessions.

On Closing Costs

Seller’s contribution towards closing costs is typically negotiated as part of the purchase agreement. The agreement will specify the amount or percentage of the contribution and any conditions or limitations.

While seller contributions are allowed and regulated by loan program guidelines, these contributions are typically limited to a certain percentage of the purchase price. The limit depends on the type of loan. Conventional or FHA or VA.

Buyers should factor in potential closing cost credits negotiated with the seller when evaluating the overall impact of closing costs vs down payment on their finances.

G. Determinants of Closing Costs vs Down Payment

While there is a bit of overlap, determinants of down payments vs closing costs vary.

On Down Payments

Down payment requirements vary based on loan programs, lender guidelines, and individual financial situations.

1. Loan Program: Different loan programs have varying down payment requirements. For example, conventional loans typically require a down payment of 3% to 20% of the purchase price, while government-backed loans like FHA loans may offer down payment options as low as 3.5% or even 0% for certain eligible borrowers, such as veterans using a VA loan.
2. Purchase Price: The price of the property being purchased directly impacts the down payment amount. The down payment is usually calculated as a percentage of the purchase price. A higher-priced property will typically require a larger down payment amount.
3. Loan-to-Value (LTV) Ratio: The LTV ratio is the loan amount divided by the appraised value or purchase price of the property, expressed as a percentage. Lenders often set maximum LTV ratios, and the down payment is calculated based on the desired LTV ratio. For example, a 20% down payment corresponds to an 80% LTV ratio.
4. Lender Requirements: Lenders may have specific down payment requirements based on their internal policies, risk assessments, and loan products. They may set minimum down payment percentages or require certain down payment amounts depending on factors such as the borrower’s creditworthiness and the loan program.
5. Borrower’s Financial Situation: The buyer’s financial situation, including income, credit score from credit reporting agencies, debt-to-income ratio, and assets, can influence the down payment requirements. Lenders consider these factors to assess the borrower’s ability to make a down payment and manage the associated financial responsibilities. Proper financial planning can ensure buyers have sufficient funds available for both closing costs vs down payment when it’s time to close on the property. Negotiating with the seller for contributions towards closing costs vs down payment can help ease the financial burden on the buyer.

On Closing Costs

Several elements contribute to determining the closing costs associated with a home purchase. The following elements commonly influence closing costs:

1. Property Value: The purchase price of the property is a significant factor in determining closing costs. Certain expenses, such as transfer taxes or recording fees, may be calculated based on a percentage of the property value.
2. Loan Amount: The size of the loan can impact closing costs. Some fees, like loan origination fees or discount points, may be calculated as a percentage of the loan amount.
3. Lender Requirements: Lenders may have specific fees or costs associated with their loan products.
4. Title Services: Title-related expenses, such as title searches, title insurance premiums, and settlement fees, contribute to closing costs.
5. Appraisal and Inspection: Costs for appraisal and home inspections, which verify the property’s value and condition.
6. Prepaid Expenses: Some closing costs involve prepaid expenses, such as property taxes, homeowners insurance premiums, and mortgage interest.
7. Escrow Accounts: Funding an escrow account to cover future property taxes and insurance payments can be part of closing costs.
8. Recording and Government Fees: Fees associated with recording the deed, mortgage, and other documents with the appropriate government authorities.
9. Miscellaneous Fees: Additional costs can include courier fees, document preparation fees, attorney fees, or notary fees.

H. Calculation of Closing Costs vs Down Payment

Down payment = Purchase price x Down payment percentage

Closing costs = Sum of all fees and expenses incurred in the home buying process. These closing fees may include, but are not limited to:

1. Transfer Taxes
2. Recording Fees
3. Title Search Fees
4. Attorney Fees
5. Appraisal Fees
6. Home Inspection Fees
7. Loan Origination Fees
8. Courier Fees

Buyers can use online calculators to estimate closing costs vs down payment based on their purchase price and loan amount.

I. Equity Value of Closing Costs vs Down Payment

Down payments contribute to the equity value of a property. Closing costs do not contribute to the equity in a property.

Equity value is the difference between a property’s market value and the outstanding balance of any mortgages or loans secured against it. In simpler terms, it is the amount of ownership or stake that a homeowner has in their property.

The higher the equity value, the higher the amount of ownership a homeowner has in their property. When a down payment is made, it goes towards the equity in the property.

Example

Consider an example where Buyer A and Buyer B both purchase a $600,000 house, but they make different down payments.

Buyer A makes a 20% down payment ($120,000) and obtains a mortgage loan of $480,000.

Buyer B, on the other hand, makes a 10% down payment ($60,000) and secures a mortgage loan of $540,000.

After the purchase, let’s assume the market value of the house remains the same. Here’s how the equity for each buyer would compare:

Buyer A:

• Purchase Price: $600,000
• Down Payment: $120,000
• Mortgage Loan: $480,000
• Equity: $480,000 (Market Value) – $480,000 (Mortgage Loan) = $0

Buyer B:

• Purchase Price: $600,000
• Down Payment: $60,000
• Mortgage Loan: $540,000
• Equity: $600,000 (Market Value) – $540,000 (Mortgage Loan) = $60,000

In this example, despite both buyers purchasing the same $600,000 house, Buyer B has more equity in the property compared to Buyer A. The larger down payment of Buyer B results in greater ownership stake or equity in the property.

Having equity in a property is beneficial because it provides:

1. Financial stability
2. Flexibility
3. Potential opportunities, such as using the equity for home improvements, refinancing, or selling the property with the potential for a profit.

Conclusion on Closing Costs vs Down Payment

The question of Closing Costs vs Down Payment is one that comes up often. Especially amongst first-time home buyers. Down payments are separate from closing costs. A down payment represents the buyer’s initial investment and contributes to the buyer’s equity in the property.

In this article, we have summarized the distinct features and characteristics of Closing Costs vs Down Payment.

It is typically calculated as a percentage of the purchase price. It can vary based on loan programs, lender requirements, and the buyer’s financial situation. A higher down payment generally leads to a lower loan-to-value (LTV) ratio.

Closing costs, on the other hand, encompass various fees and expenses associated with the home buying process. They are separate from the loan amount and typically include charges related to title services, appraisals, inspections, and other transaction-related services. While closing costs cannot be eliminated entirely, buyers can shop around for different service providers to potentially reduce their costs.

Understanding the factors that influence closing costs vs down payment can help home buyers make the best financial decisions.

Sincerely,

Your Mortgage Minister