Real Estate Closing
Real estate closing is the transfer of the real estate title from seller to buyer according to the sales contract—the buyer receives the title to the real estate and the seller receives the money. However, there are numerous requirements and costs associated with closing that make it more complex than buying something at a store. Both requirements and costs result from the sales contract itself, from tradition and local custom, and from local, state, and federal laws. Most real estate closings use the services of an escrow agent, who serves as a third-party that both the buyer and the seller can trust and who coordinates the activities between buyer and seller according to the sale and purchase agreement. The duration of the steps necessary to close a real estate transaction is known as escrow. Closing costs range from 3% to 6% of the mortgage; equaling $9,000 to $18,000 on a $300,000 loan.
Just before escrow is closed, both the buyer and the seller receive a closing statement from the escrow officer, which lists the purchase price and all of the expenses associated with buying the property and how those expenses will be allocated between the buyer and the seller. Expenses typically allocated to the seller include the broker's commission, ½ of the escrow fees, recording fees for the loan payoff, seller's title policy, and state or local revenue stamps, indicating the payment of any excise taxes. Expenses typically allocated to the buyer, besides the purchase price, include ½ of the escrow fees, lender's title policy, loan origination fee, loan commitment fee, appraisal of the property, recording fee for transfer of title, and possibly a fee for the credit report.
Many of the fees listed on the closing statement will have already been paid outside of closing (POC), directly to the service providers as well as other expenses typically associated with closing, such as credit report fees, loan application fees, appraisal fees, and other closing expenses. Nonetheless, it will be useful to have all the expenses listed on 1 statement for easy reference when the property is sold.
Additionally, the final closing statement also has credits and debits, which are paid out of escrow on behalf of the party being debited. Naturally, what is a credit to the buyer is a debit to the seller, and vice versa. Items that are typically credited or debited include the selling price, loan principal and associated points or fees, prepaid interest, earnest money deposit and any down payment, unpaid bills associated with the property, such as utility charges and taxes, and prepaid expenses such as property taxes, insurance, and other expenses; security deposits from any tenants; any remaining loan balance that the seller must pay, and the costs associated with property inspection and appraisal.
Right before the closing, the buyer will want to be sure that everything is in order. The buyer should inspect:
- the title evidence;
- the seller's deed;
- proof that encumbrances have been removed;
- the survey showing the exact boundaries of the property;
- the results of any inspections, repairs, or alterations;
- and any leases that pertain to the property.
Most sales contracts allow the buyer to make a final inspection, or walk-through, of the property right before closing, usually with the broker, to ensure that the property has been maintained, that agreed-upon repairs were made, or that there were no other significant alterations of the realty that were not planned.
So that the buyer will know the exact boundaries of the property, a survey is usually done, which also shows the placement of buildings, driveways, fences, and other significant landmarks, and will also show any encroachments from or to adjoining property. Sometimes the buyer relies on old surveys of the property, but usually the lender or title company may require a new survey. The sales contract may specify whether the buyer or seller pays for the survey.
Both buyer and seller will want to inspect the closing statement to ensure that everything is in order. The seller will also want to be assured that the buyer has the money to close the transaction.
If the seller has a mortgage or other liens, then he will have to obtain a payoff statement for each lien that lists the exact amount of money needed to pay off the mortgage or lien on the property as of the date of the closing. The payoff statement will usually include not only the remaining principal and interest, but also any prepayment penalties and the fee for issuing a certificate of satisfaction (aka satisfaction piece). The seller will receive credit for any reserves in escrow to pay for future taxes and insurance.
If the buyer is assuming the seller's mortgage, then the buyer should get a mortgage reduction certificate from the mortgagee, which will list the exact amount of the balance as of the closing date, the interest rate, and the date of the last payment.
The main purpose of preclosing procedures is to ensure that everything is in order: surveys, property insurance, title insurance, title certificate, and the mortgage. The lender may also require that the buyer deposit money in an escrow account to pay for insurance and taxes for the property, to protect its collateral.
To be sure that the buyer is receiving good title, the buyer and the lender require that the seller delivers either a current abstract of title, which will list most encumbrances, or a title commitment from a title insurance company. The seller generally pays for this title search.
If a title abstract is delivered, the buyer's attorney should examine it to write an opinion of title, which will list all encumbrances—which includes liens, easements, and deed restrictions—that are in the title record, and whether the title is good. It is not, however, a guarantee of good title.
Since the seller's title search is generally done weeks or months before the closing, the buyer should do a 2nd search of the title record right before closing to ensure that no new encumbrances have been added to the record, especially if the seller is financially distressed.
Because it takes time to record new encumbrances, the seller is generally required to sign an affidavit of title, in which the seller swears, to the best of his knowledge, that nothing has occurred since the seller's title search to cloud the title, and that there have been no events that would possibly call into question the seller's ownership rights or that would give others an interest in the real estate, such as would occur for unpaid property improvements that could subject it to a mechanic's lien.
If anything on the affidavit of title proves to be false, then the title insurance company or buyer can sue the seller for damages.
Closing is the actual settlement and transfer of the real estate title and the money. It can either be face to face, where all parties and their representatives meet in a room to exchange documents, or it can be done through an escrow agent, who, as a disinterested party, receives all of the documents and finalizes the settlement and transfer.
Most real estate closings must be reported to the Internal Revenue Service using Form 1099-S, Proceeds from Real Estate Transactions, listing the seller's social security number, the sales price, and any reimbursements to the seller of prepaid property taxes. Typically, the closing agent reports to the IRS, or, in some cases, the lender.
If a business entity is going to take title of the property, then the buyer should inform the escrow agent, so that the title can be properly prepared. The escrow officer closes the transaction and records the deed when all the requirements of escrow and the purchase agreement are satisfied, including the transfer of money. Although the actual process of closing escrow varies throughout the country, there are some common elements. Generally, the parties get together, all necessary documents are signed and notarized, then funds are transferred from the buyer to the seller. Both the seller and the buyer will receive an estimated closing date, so the parties should ensure that there are no mistakes; otherwise, corrections will have to be expedited or the closing of escrow will have to be delayed. Generally, the escrow agent will tend to overestimate expenses that will need to be paid on the closing date, so that there is no shortage of funds. If the estimated amounts are too high, then it is easy enough to credit the amount to the appropriate party.
Real Estate Settlement Procedures Act (RESPA)
The Real Estate Settlement Procedures Act (RESPA) was designed to inform the buyer of real estate about closing costs and to prevent abusive practices that inflate the costs of closing for the buyer. This federal Act, administered by the Housing Urban and Development (HUD) agency, applies to any closing using first-lien federally related loans, which includes most mortgages, for residences, condominiums, and cooperatives consisting of 1 to 4 units. It requires that the lender disclose the costs of the closing to the borrower and prohibits the lender from demanding excessive deposits for escrow accounts, which are accounts required by most lenders to pay for future real estate taxes and insurance premiums. RESPA also prohibits referral fees, such as kickbacks, for directing the buyer to other services, such as a specific lender.
Some brokerages have a controlled business arrangement (CBA) that allows it to offer several related home-buying services, such as for title insurance, home inspections, and even moving. These business relationships must be disclosed. The brokerage may also offer computerized loan origination (CLO) services that allow a potential buyer to easily shop for a loan. However, RESPA requires that the broker inform the buyer that she can shop for those services elsewhere, and is not restricted to using only the settlement services provided by the CBA or the CLO.
RESPA has the following specific requirements:
- within 3 days of the loan application,
- the borrower must receive a special HUD settlement cost information booklet that provides an explanation of closing and its costs;
- the borrower must receive a good-faith estimate of the settlement costs;
- determine whether the lender will require a specific escrow agent to close the transaction;
- the buyer and the seller have a right to review a filled-in Uniform Settlement Statement (HUD-1 Form) at least 1 business day before closing.
The HUD-1 form itemizes all charges that are paid by either the buyer or the seller at closing. Items that were paid by either party outside of closing do not have to be listed. However, if the lender required that any charges be paid before closing, then these must be listed as paid outside of closing (POC).
The lender must issue a mortgage servicing disclosure statement that includes information that the borrower would need to resolve any current or future complaints against the lender. Lenders are required to state whether they are going to keep the loan on their books or transfer the loan to a mortgage servicing company, because that will be the company that the borrower will be dealing with in regard to payments and any customer service issues.
TILA-RESPA Integrated Disclosure (TRID) Regulation
Starting on Oct. 3, 2015, a new rule by the Consumer Financial Protection Bureau — aka TILA-RESPA Integrated Disclosure (TRID) regulation, "Know Before You Owe" rule — requires several documents be given to the homebuyer before closing. When a homebuyer applies for a new mortgage, the lender will give him a copy of the Your Home Loan Toolkit by the CFPB, outlining the steps in the mortgage application process. Additionally, the homebuyer should receive a Loan Estimate (LE) document from the lender containing information required by the Truth in Lending Act (TILA) and the Real Estate Settlement Procedures Act (RESPA) that lists the terms of the loan, including the interest rate and all closing costs, and the amount of cash it will be required to close the transaction. The LE document will allow the homebuyer to shop around for a mortgage. The CFPB recommends that the borrower obtain LE documents from at least 3 different lenders.At least 3 business days before closing, the homebuyer must also receive a Closing Disclosure that will list all of the costs and expenses that the borrower must pay at closing. The Closing Disclosure has the same format and lists much of the same information as the LE document, so the borrower should compare the Closing Disclosure with the LE to see if the interest rate or any of the fees or other expenses have changed.
Any changes in the Closing Disclosure that differ from the LE document but was not previously agreed to by the home buyer will reset the 3-day disclosure period if there is an increase in fees or any additional fees or if the interest rate increases by more than 12.5 basis points for a fixed-rate loan or 25 basis points for a variable-rate loan. However, lower fees or a lower interest rate will not reset the disclosure period, since it benefits the buyer. The purpose of this change in rules is to prevent abuses by lenders, title companies, or real estate brokers from inserting new fees or increasing the fees or interest rate on closing day, when many documents have to be signed by the buyer to close the real estate transaction. Resetting the disclosure period allows the buyer to adequately consider any changes or to consult with a lawyer or housing counselor concerning the changes. Buyers will be able to undo the loan if the new disclosure rules are not followed.
A face-to-face closing is where all parties and their representatives meet at a specific place and time, usually at an office of one of the party's representatives, to exchange the documents and to ensure that all necessary steps have been taken so that the buyer can receive marketable title and the seller receives his money. Hence, this type of closing is often referred to as passing papers.
One person—the broker, an attorney, or a lender's or title company's representative—conducts the meeting.
When the documents are exchanged, they are recorded in the proper order so that the chain of title is not interrupted. For instance, the certificate of satisfaction must be recorded before the seller's deed to the buyer. And only after the title is transferred to the buyer can the buyer pledge the property for a mortgage.
Closing in Escrow
Because the requirements of settlement and transfer are stipulated by the sales contract and by law, the procedure of closing in escrow is basically the same as a face-to-face closing except that all of the documents are sent to an escrow agent, who is a disinterested 3rd party, with no relationship to either the buyer or the seller or their representatives. The main benefit of closing in escrow is that the parties and their representative do not have to meet—they just send the required documents to the escrow agent, who then examines to make sure everything is in order, then effects the settlement and transfer.
The escrow agent has the right to examine the title to ensure that there are no defects and that all conditions are satisfied. If everything is in order, the escrow agent sends the seller the purchase money, and records the deed for the buyer, and the mortgage, if any.
If the title has defects, the escrow agent will deduct the amount necessary to remove the liens from the seller's money. If the title cannot be cured, then the agent will return everything to the senders of the material, effectively cancelling the sale.
At closing, there are expenses that either the buyer or seller is wholly liable for and is expected to pay. Most of these costs are closing costs, which pay for closing itself rather than for the property or bills associated with the property. Some of these expenses include the following:
- Buyer usually, if applicable, pays for:
- Loan costs
- origination fee
- discount points
- appraisal fee required by lender
- credit report
- lender's inspection fee
- mortgage insurance application fee
- assumption fee
- Other payments required by lender
- mortgage insurance premiums
- hazard insurance premiums
- title insurance
- survey fees
- Government recording and transfer charges
- recording fees and releases
- municipal taxes or stamps
- state tax or stamps
- Other settlement expenses, if applicable:
- commission for buyer's agent
- buyer's attorney fees
- Loan costs
- Seller usually pays for:
- broker's commission
- title search
- prepayment penalties, if any
- certificate of satisfaction fee
Tax stamps are excise taxes assessed on the sale of the property. Property ad valorem taxes and homeowner association fees are prorated, paid proportionate to the time of ownership during the year.
The buyer should retain the closing statement, because it serves as the initial cost basis for the buyer, which will be needed to determine the capital gain or loss on the property when the property is sold. Additionally, the closing statement will also have deductible expenses, such as property taxes, insurance, and loan points.
Getting Long-Term Financing for Closing Costs
By getting the seller to pay some of the closing costs in exchange for a higher sales price, the buyer can get long-term financing for the closing costs. However, the addition of the closing costs cannot increase the price of the property beyond its appraised value, since the lender will not approve the loan. Lenders want the appraised value to be at least equal to the price paid, which will be more than the loan amount.
There are some expenses at closing where both buyer and seller have some liability. When a sales contract is finally signed, the sales price is agreed upon. When buying an item at a store, the buyer pays the purchase price and maybe some sales tax in return for the item. But a real estate sale is not that simple because there are bills associated with the real estate that the seller has already paid for a certain period, during which both seller and buyer will have owned the property, or there will be bills covering the same period that the buyer will have to pay later on. A large part of the closing is the proration of these expenses between buyer and seller according to how long each will have owned the property during the time period covered by each bill.
Most closings use prorations that are calculated through the day of closing, meaning that the seller is assumed to own the property on the day of closing. If the prorations are to be calculated up to the day of closing, then the buyer is assumed to own the property on the day of closing. Which method is chosen depends on the sales contract, the traditional approach for the locale, or state law.
Proration results in credits and debits for both buyer and seller. A credit for the seller increases the amount that he is entitled to receive whereas a credit for the buyer decreases the amount that she must pay. A debit for the seller decreases the amount that he is entitled to receive whereas a debit for the buyer increases the amount that she must pay. The major credit for the seller is the sales price of the property, which is also the major debit for the buyer. Credits and debits are netted to determine the amount of money that the buyer actually pays to the seller at closing.
Bills can be divided into prepaid items, which are expenses that have been paid by the seller at the beginning of the billing period, and accrued items, which are expenses that will be paid by the buyer at the end of the period. Prepaid items are credits to the seller and debits to the buyer; accrued items are debits to the seller and credits to the buyer. Hence, it is obvious that what is a credit to the seller is a debit to the buyer, and vice versa.
The proration of most expenses, including taxes, mortgage, interest, and insurance premiums, in most localities uses a 360-day year, called a banker's year (aka statutory year), which is divided into 12 30-day months. The actual proration is then determined by summing the monthly bills and daily bills according to the following formulas:
Monthly Rate = Yearly Rate / 12
Daily Rate = Monthly Rate / 30
Prorated Credit or Debit = (Number of Full Months × Monthly Rate) + (Number of Days in the Partial Month × Daily Rate)
Example — Proration of an Accrued Item or Prepaid Item Using a Banker's Year
The buyer and seller close on October 18. Real estate taxes of $3,600 on the property will be paid by the buyer at yearend. Then, using a banker's year, the calculations are as follows:
- Monthly Prorated Rate = $3,600 / 12 = $300
- Daily Prorated Rate = $300 / 30 = $10
- Prorated Debit to Seller = $300 × 9 + 18 × $10 = $2,880 = Prorated Credit to Buyer.
If the real estate taxes had been prepaid by the seller, then the credit to the seller and the debit to the buyer would equal:
- Prorated Credit to Seller = $300 ×2 + 12 × $10 = $720 = Prorated Debit to Buyer.
Note that $2,880 + $720 = $3,600, the total real estate tax for the year.
Some prorations, such as for the division of rents from the property, use a 365-day year (366 in a leap year). In this case, a daily bill is calculated, then multiplied by the number of pertinent days:
Daily Rate = Yearly Rate / 365
Prorated Credit or Debit = Daily Rate × Number of Days in Relevant Period
Example — Proration of Rents
The buyer is closing on December 15 on a property that has a studio that is rented out for $310 per month, which the seller received at the beginning of December. The sales contract calls for prorating the rent through the day of closing, so the buyer is entitled to the rent for the 16 days remaining in December.
Rents are calculated using the actual number of days, but because rent is paid month to month, only the number of days in the month of the closing needs to be counted.
- Daily Rent = $310 / 31 = $10
- $10 × 16 = $160 = Debit to Seller = Credit to Buyer
The rent deposit is transferred from seller to buyer, so the deposit is a debit to the seller and a credit to the buyer.
- the money for the property is paid, the buyer signs the closing documents and releases the money;
- the seller signs the deed legally transferring the property to the buyer;
- the buyer receives title insurance guaranteeing the validity of the title on the property.
The seller usually signs the deed in front of a notary public, who verifies that the signature is by the person so designated. The buyer's name is also be on the deed, but the buyer does not have to sign the document.
The final step in closing is recording the deed. Although the procedure varies somewhat throughout the country, there is generally a recorder of deeds in the county courthouse. In many parts of the country, the recording of documents and their retrieval is being performed electronically, greatly shortening the time for recording and retrieving deeds. After everything is signed, the deed will be recorded in the county recorder's office, along with the mortgage or the deed of trust document.
Tips to Reduce Closing Costs
Closing costs typically range from 3% to 6% of the loan amount, but there are some ways to reduce these costs:
- Ask lenders for an official Loan Estimate, that details the costs and terms being offered. Be sure to get the legally binding Loan Estimate to compare costs, not a "closing costs work sheet" or a "fee itemization" offered by some lenders.
- Section C, page 2 will list services that you can shop around for, including the following:
- Pest inspection
- title search
- title insurance binder
- This covers both the buyer and seller during the transfer.
- lender's title policy
- settlement agent
- Some money may be saved on the pest inspection and survey, but hundreds of dollars may be saved on title insurance and settlement services, which may be combined.
- Compare total prices regardless if the company considers it a buyer's cost or seller's cost and ensure that each quote covers the same services.
- Avoid or re-negotiate fees with vague names, such as a "funding fee" or "delivery fee."
- Avoid prepaid or per diem interest for the period between your loan closing and the start of the new month by closing at the end of the month. The amount of this interest equals the daily interest rate multiplied by the number of days left in the month. The daily interest rate can be calculated thus:
- Daily Interest Rate = Annual Interest Rate ÷365 Days
- Ask the lender about any discounts or rebates available.
You may also be able to get a no-closing-cost loan, where the closing costs are added to the loan principal or are covered by charging a higher interest rate. This type of loan may only make sense if you intend to stay in the house for only a few years.
Your lender will monitor your credit right up until closing. Therefore, before closing on your new home, never do anything that may increase your credit risk, such as changing jobs, taking out additional loans, or increasing your debt, such as using cash advances from credit cards to pay closing costs or the down payment. Otherwise, the lender may cancel the loan.