Amortizing Loan Closing Costs: A Simple Explanation

Closing costs are the various fees charged by lenders and third parties to process and close a mortgage loan. These costs can range from 2% to 5% of your total loan amount. Since closing costs can tally into the thousands of dollars, you may be wondering – can I spread these costs out over my loan term rather than pay upfront? The answer is yes, you can amortize your closing costs over the life of your mortgage through a slight interest rate increase. Understanding how amortizing closing costs works can help you budget for these fees at closing.

What Are Closing Costs?

When you purchase a home with a mortgage various fees are charged beyond just the down payment. These extra costs are known as closing or settlement costs. Typical fees include

• Origination fees – Charged by the lender to cover processing costs

• Appraisal fee – For the appraiser to evaluate the property

• Credit report fee – To pull your credit history

• Title fees – Paid to a title company to research the home’s title and facilitate the closing

• Recording fees – To officially record the deed transfer and new mortgage

• Home inspection fees – If you choose to have the home inspected

• Homeowners insurance – Lender requires first year of insurance premium upfront

• Property taxes – Prorated amount due at closing

• HOA fees – If part of a homeowners association

Closing costs typically range from 2% to 5% of your loan amount. So on a $250,000 mortgage, you may pay $5,000 to $12,500 in various closing fees. Lenders are required to provide a detailed estimate of all costs on the Loan Estimate form when you apply. This helps you budget and compare lender fees.

Why Amortize Closing Costs?

Since closing costs can run into the thousands of dollars, many home buyers choose to roll these fees into their mortgage loan balance through a process called amortization. Reasons you may want to amortize closing costs include:

• Avoid paying large fees upfront in cash

• Keep more cash free for your down payment and moving expenses

• Pay closing costs over time through your monthly mortgage payment

• Reduce the amount you need to save for closing

Amortizing costs does increase your loan amount and total interest paid over the loan term. However, for some buyers this is worthwhile to free up cash at closing.

How Does Amortizing Closing Costs Work?

When you opt to amortize closing costs, the lender adds the fees onto your mortgage loan balance. However, they cannot simply increase your principal. This would affect the loan to value ratio.

Instead, the lender increases your interest rate slightly to generate additional interest income that equals the closing costs. This is how they recover the fees over time through your monthly payments.

For example:

• Loan amount: $200,000

• Closing costs: $4,000

• Original interest rate: 3.5%

To amortize the $4,000 in fees over 30 years, the lender increases your rate by about 0.125% to 3.625%. This adds roughly $12 more to your monthly mortgage payment. Over 360 payments, this extra interest totals $4,000 – exactly enough to recoup the closing costs.

As you can see, amortizing adds only a minor increase to your interest rate and monthly payment. But it saves you from paying thousands in closing costs up front.

Amortization Schedule with Closing Costs

An amortization schedule maps out exactly how your mortgage principal and interest payments are applied over the full loan term. Here is a sample 30 year schedule with and without closing costs amortized:

No Amortization

• Loan amount: $200,000

• Interest rate: 3.5%

• Monthly payment: $898

With Amortization

• Loan amount: $204,000 ($200,000 + $4,000 in fees)

• Interest Rate: 3.625%

• Monthly Payment: $909

As you can see, amortizing the $4,000 in closing costs increases monthly interest and principal payments slightly. But it eliminates the need to pay closing costs in cash at closing.

Should You Amortize Closing Costs?

Despite the benefits, amortizing fees isn’t right for everyone. Consider these pros and cons:

Potential Pros

• Pay costs over loan term through regular payments
• Avoid large out of pocket fees at closing
• May increase loan approval odds by lowering upfront cash needed
• Keep cash free for down payment and moving

Potential Cons

• Increases loan balance and total interest paid
• Results in a slightly higher monthly mortgage payment
• Makes it harder to build equity as less principal is paid off early
• Can increase interest rate above qualifying cutoff for loan program

Take time to run the numbers and decide if the interest savings outweigh paying fees in cash for your situation. Many first time home buyers choose to amortize costs to lower cash needed at closing. But higher income buyers often prefer paying outright. Evaluate both options to make the right choice for your budget and goals.

Alternatives to Amortizing Closing Costs

If you don’t want to roll fees into your loan, here are alternatives to amortizing closing costs:

• Shop lenders – Compare Loan Estimates and negotiate lower origination fees. Ask if they have closing cost specials.

• Buyer credits – Ask seller to pay some closing costs through a credit at closing. Common for competitive markets.

• Lender credits – Lender may offer a credit, often in exchange for a slightly higher rate.

• Points – Pay points to lower interest rate and monthly payment, saving more over loan term. Can offset costs.

• Savings – Increase down payment savings to have cash on hand for closing fees.

• Gift funds – Family gift money can specifically help cover your closing costs.

Many buyers combine multiple options to minimize out of pocket costs such as gifts, seller credits, and shopping rates. Explore all avenues to reduce cash needed at closing.

Closing Costs to Avoid Amortizing

Most standard closing fees charged by the lender and third parties can be amortized into your loan. However, there are certain costs you generally need to pay upfront:

• Down payment funds
• Home appraisal fee
• Credit report fee
• Home inspection fee (if getting an inspection)
• Homeowners insurance premium
• Property taxes due at closing
• HOA fees due at closing
• Any seller assist credits

The down payment and upfront costs must be paid in cash when you close. Term fees from third parties can usually be amortized. Your Loan Estimate from the lender will outline which specific closing costs can and cannot be financed.

How to Request Amortizing Closing Costs

If you decide amortizing makes sense, follow these steps:

• Get a Loan Estimate listing all estimated closing costs
• Determine total amount you want to amortize
• Notify lender you want to roll specified fees into loan balance
• Lender will recalculate interest rate and monthly payment
• Review revised Loan Estimate and confirm if still want to amortize costs

This simple process is handled during the loan application stage. Communicate your intent clearly so the lender can adjust your proposed interest rate and fees accordingly.

Amortizing Points on Your Mortgage

Another way borrowers amortize costs is through discount points. One discount point equals 1% of the loan amount. Each point prepays interest and can lower your rate by about 0.25%.

Paying points benefits borrowers who plan keeping their mortgage long term since the interest savings outweighs the upfront fee over time. Points can also offset other closing costs. For example:

• Loan amount: $200,000

• 1 point costs $2,000 upfront

• Lower interest rate by 0.25% saves about $55 per month

• Over 30 years, the monthly savings totals $19,800

As you can see, discount points can more than pay for themselves over the long run through lower interest. You’ll still pay the point cost upfront however. But you recoup it gradually through a