Closing Cost Reform: Long Overdue and Worth the Fight (Part 1)
Introduction
President Biden recently addressed the pressing issue of housing affordability in his recent State of the Union (SOTU) speech, announcing several initiatives to tackle it. Most of his homeownership-related proposals were variations of the tax credit and downpayment assistance programs already much discussed by his party’s policymakers. Unexpectedly, he also identified high closing costs as a significant obstacle to home affordability. In particular, he called out title insurance1 for potential cost savings.
Just days later, the National Association of Realtors (NAR) settled a class-action lawsuit in Missouri, in which it was the main defendant. The lawsuit alleged that the defendants engaged in practices to restrict price competition in single-family brokerage commissions, in particular for homebuyers. The jury had earlier found NAR guilty, and the announced settlement included industry practice changes that were broadly seen as a long overdue step that should lead to lower brokerage commission rates.
Together, these two events make clear that closing costs are moving to the front burner of housing policy. Specifically, they highlighted how home buyers and sellers have been paying unduly high prices for both brokerage and title insurance, which are two of the very largest closing costs.
Part 1 of this article will address several questions to lay the groundwork for a broader discussion about closing and related transaction costs in Part 2. Both parts will show that closing costs are an area of the market where normal price competition has been widely subverted, leading to unduly high costs. This has led to an unjustifiable and unfair economic burden on home buyers and sellers, particularly first-time homebuyers (FTHBs), who are already struggling with affordability. Part 2 will discuss possible solutions to help restore normal price competition for closing costs.
Closing costs are large and a barrier to homeownership2
Vendor-related closing costs3 break down into two categories: those paid by the seller and those by the buyer. For the seller, these costs are mostly the brokerage commission, long stuck in the 5 to 6 percent range, plus lawyer fees and a few small items. For the buyer, closing costs vary significantly by state, reflecting different state regulations and laws. As a percentage of the transaction amount, they also vary by size, with buyers paying a lower percentage for closing costs on larger transactions and a higher percentage on smaller ones.
On average, the total closing costs incurred by both buyers and sellers for vendor-provided services, including both buy- and sell-side closing costs, are estimated to be at least 7 to 11 percent.4 For a $300,000 home, that amounts to a significant $21K to $33K. If these costs were generated by an efficient and competitive market for vendor-related closing costs, then that would just be the economic reality associated with transferring ownership of a custom and illiquid asset like a home. However, if these costs reflect distorted markets where normal price competition has been subverted, then it is absolutely appropriate and reasonable for the government to intervene and improve the situation.
This is particularly important to FTHBs if unnecessarily high prices show up in closing costs paid by the buyer. Such FTHBs need to meet two hurdles to afford a first home. On a monthly basis, they need sufficient income to carry mortgage payments, property taxes, etc. An even tougher hurdle may be saving enough cash upfront to both make a downpayment and pay for those buy-side closing costs.
Historically, a 20 percent downpayment was the standard, against which buyer-paid closing costs were comparatively modest. But that 20 percent requirement comes from an earlier era. In the last decade, the average FTHB has made a downpayment in the range of 6 to 7 percent.5 This is because the government has put considerable time and resources into developing lower downpayment alternatives that are still of acceptable credit quality to the government agencies that provide most mortgage credit today.6 However, this is based on the average FTHB, many of whom are from younger households with high incomes or access to family wealth. For the potential FTHB with a combination of credit rating and downpayment savings that is instead near the bottom of the range of what is acceptable to lenders - which is where government policy can be particularly impactful in enabling renters to become homeowners - I estimate the average downpayment is more in the 4 to 5 percent range, i.e., roughly equal to the amount of buyer-paid closing costs already estimated at 2 to 5 percent.
This means that nearly half of the total cash needed by many FHTBs to purchase that first home is for closing costs! Thus, the government, after having done so much to reduce downpayment requirements, is right to focus its current efforts on making sure buyer closing costs are reasonable and reflect an efficient and competitive marketplace. The numbers mentioned above make it clear that this approach has the potential to materially improve housing affordability and increase access to homeownership.
Insights from the NAR lawsuit and settlement
In 2023, the NAR and certain large brokerages were sued in Missouri federal court via a private class-action lawsuit. The lawsuit was targeted at practices that the NAR required its real estate broker members to use, which, according to the plaintiffs, were designed to subvert brokerage price competition in the marketplace, especially for homebuyers.
As background, the Justice Department (DOJ) has been investigating the NAR for decades because of concerns that those required practices had the effect of subverting price competition in the single-family real estate brokerage business.7 According to the DOJ and NAR critics, this led to commission rates remaining unfairly high at 5 to 6 percent for decades.
The Missouri lawsuit focused specifically on how those practices impacted buyers, who, as a result, had no ability to shop for unbundled buyer-broker services, virtually requiring them to take a full-service package. The lawsuit also focused on the rather unconventional approach to how the buyer’s broker was paid: the buyers’ brokerage commission was set and paid by the seller’s broker, with the buyer having no say in the matter.
The jury found the defendants guilty and ordered the NAR and others to pay $1.8 billion in damages to an estimated half-million Missouri-based homebuyers.
Then, right after the SOTU speech, the NAR announced a settlement of that lawsuit that called for paying reduced damages and agreeing to make changes in its rules to, hopefully, restore normal price competition.8 The DOJ was involved behind the scenes and indicated at the time that it supported the proposed changes as adequate to restore price competition.9 (Interestingly, since then, the DOJ has undertaken additional legal actions about the NAR and its required rules. So, this is still an evolving situation.)10
Based on the commission levels found in most other industrialized countries – long reported to average roughly 3 percent or even lower – critics of the NAR frequently cite that commissions could well be cut in half.11 For a typical $300,000 house, that could save between $7,500 to $9,000, a sizeable amount.
The case of title insurance
Mortgage lenders routinely require homeowners to purchase title insurance when financing or refinancing their homes. Such insurance covers certain hazards that could arise, such as discovering post-closing that ownership is still held by another party. While this is a worst-case scenario, it is more likely that the coverage will protect against limited claims, such as unpaid property taxes or mechanic’s liens.
Title insurance is actually two separate title policies on the same home. A lender’s title policy, which is required by virtually all lenders, specifically protects that lender against the loss of value of the collateral supporting its mortgage loan and lasts until the mortgage is paid off. An owner’s title policy, which is not mandatory but most homeowners purchase anyway, protects a homeowner’s equity and lasts until the property is sold. For the sake of simplicity, this article will mainly focus on lender’s title insurance.
The president’s decision to specifically target title insurance makes sense for two reasons. First, it is a significant contributor to buyer-paid closing costs. The cost of the lender’s title policy, which is paid by the homebuyer via a single, upfront payment made at the closing, will vary from state to state, reflecting that the states regulate title insurance. Nevertheless, as a generalization, the cost is between 0.5 and 1.0 percent12 of the mortgage amount. Many states even set the price for title policies, eliminating price competition among different providers. In dollar terms, for a median-priced house purchase, I estimate the resulting average cost of lender title policies at the typical closing (and reflecting the recent large run-up in house prices) would be above $2,000. For a first-time homebuyer purchase financed by a mortgage, the cost would roughly average $1,500. (I emphasize the ballpark nature of these estimates, as each state has different rules and market practices.) Compared to an FTHB downpayment that might only be $10,000 to $15,000,13 this is material (defined as 10 percent or more).14
Second, the reason for the focus on title insurance is that it is objectively very overpriced.15 Specifically, the “loss ratio” tells a very clear – and damning – story. In the insurance business, the loss ratio – i.e., policy payouts (and associated expenses) divided by policy revenues (called premiums) – is a standard industry cost measure. The National Association of Insurance Commissioners (NAIC) collects data on the loss ratio of various types of insurance. For life insurance, it typically ranges from 60 to 90 percent, and for auto insurance, it is more like 70 to 80 percent. For health insurance, the Affordable Care Act actually requires that the loss ratio (known as the “medical loss ratio”) be at least 80 to 85 percent for the insurance to be considered appropriately priced. There are good reasons for variation between the products cited above, such as investment income being higher for longer-lived products (like life insurance) versus shorter-lived ones (like auto insurance).16
But what stands out is the extraordinarily low loss ratio for title insurance. It averaged just 6 to 7 percent per annum a decade ago but has been trending down since, most recently being around and even under 3 percent!17 This means that the business’s gross profit margin is an astounding 97 percent.
Can such a high gross profit margin be considered reasonable? It certainly isn’t justified by the history of losses in the title insurance business. In fact, when it comes to home purchases or refinancing, the buyer’s legal counsel typically conducts a pre-closing search to ensure a title is without defect. It should, therefore, come as no surprise that few losses show up post-closing.
In 2007, the Government Accountability Office (GAO), a non-partisan research arm of Congress, studied title insurance. The report, titled “Title Insurance: Actions Needed to Improve Oversight of the Title Industry and Better Protect Consumers,”18 provided an analysis of the title insurance industry. Although it used appropriately neutral and careful language, it nevertheless was a scathing report. On the topic of how the homebuyer does not, in reality, select the title insurer (as would be normal when consumers buy most things),19 there is instead what economists call “third-party selection.” I will quote at length:
“…large insurers tended to use local or regional title agents to conduct their business, and the mix of affiliated agents (those in which the insurer has an ownership interest) and independent agents varied across states. The extent of affiliated business arrangements (ABAs) – situations in which real estate or other professionals are part or full owners of the title agencies – also varied.
“…consumers generally do not select their title agent or insurer, and title agents do not market to consumers but rather compete among themselves for referrals from those who do – that is, real estate and mortgage professionals [emphasis added]. This arrangement can create conflicts of interest if professionals making the referrals have a financial interest in the agent recommended. HUD and state insurance regulators have recently identified instances of alleged illegal activities within the title industry that appeared to compensate real estate agents, builders and others for referring customers to particular title insurers or agents. These alleged activities, which include referral fees, captive reinsurance arrangements and inappropriate ABAs, potentially reduce price competition and, according to some insurance regulators, could indicate excessive pricing by insurers.”
When a third party is responsible for making buying decisions on a consumer’s behalf, vendors tend to focus their marketing efforts towards that third party to win the business. In doing this, the vendors incur additional expenses to pay for things like lavish travel and entertainment costs, referral fees, sharing of revenues, and so on. The 2007 GAO report indicates this has been the historic practice in the title insurance business. This means that insurers must increase the cost of their policies to pay for such expenses; also, the third parties will tend to sell the policies that benefit themselves the most, which will be positively correlated with the policies that are higher cost.20 All of this is obviously not in the consumer’s best interest.
As indicated by the GAO report, the title insurance feature that appears to have the most impactful effect today on enabling and enshrining third-party selection – and its consequent high costs – is the multi-layered distribution system of regional and local title companies that are often partly owned by one or more of the many people involved in real estate closings (e.g., lawyers, brokers, etc.).21
In other words, much of the 97 percent gross margin goes to expenses to market to third-party selectors via that multi-layered distribution system, plus overheads. Thus, a large share of expenses is actually economically of no value to the lender or homeowner, who are the beneficiaries of the title policies. Those high expenses instead unduly benefit the various rent-seeking22 intermediaries involved. This is very far from the efficient, competitive transaction that consumers deserve, thus fully justifying the White House’s focus on it.
Specifically, how overpriced might title insurance be? The state of Iowa provides a method to estimate this. Alone among the states, Iowa forbids title insurance from private sector companies and instead has had a state unit provide title policies to homeowners and home lenders since 1947.23 This approach has proven effective for Iowa, as its title insurance unit historically prices its policies reasonably well, making a small profit over time.24 This makes its pricing a reasonable proxy for what title insurance might cost in an efficient and fully competitive marketplace. Using a title cost range of 0.50 to 1.00 percent, on a $300,000 house, title insurance would cost $1,500 to $3,000 in the other states. By comparison, Iowa would charge just $175, i.e., at least 90 percent lower.25 In short, it is reasonable to conclude that the overpricing could be up to ten times higher – or, in this example, a minimum of over $1,300 higher on average for first-time homebuyers – than the current rates.
Conclusion
In this Part 1, we have established that closing-related costs are quite significant, especially for FTHBs. As the government has successfully implemented low downpayment mortgage products, closing costs now account for roughly half of all the cash needed upfront by many first-time homebuyers to purchase a home.
By examining both the recently-announced NAR settlement and the closing cost specifically called out by the president – title insurance – it is clear that the costs of both are indeed higher than they should be. This is because, in each case, a normal, competitive market has been subverted. In the NAR case, the industry association has been found guilty of establishing practices that do just that. In the title insurance case, the GAO report makes it clear that third-party selection is responsible for driving up costs. This subversion of market competitiveness has been estimated to nearly double the cost of a competitive brokerage commission and has driven up prices for title insurance as much as ten times. First-time homebuyer affordability is significantly impacted specifically by the overpricing of title insurance, as it is the buyer who pays for it.
Part II will address how these two products are not one-offs, and present evidence demonstrating that the problem of unduly high transaction costs for home buying and selling is more generalized. It will then propose a reason why that is and what avenues there are to better ensure that consumers buying and selling homes in the future are treated fairly by an efficient and competitive marketplace.
Footnotes
[1] See the White House Fact Sheet: https://www.whitehouse.gov/briefing-room/statements-releases/2024/03/07/fact-sheet-president-biden-announces-plan-to-lower-housing-costs-for-working-families/.
[2] A recent article on this topic containing various useful statistics confirms how burdensome closing costs can be. The very first paragraph summarizes the situation: “Soaring home prices are making homeownership significantly less affordable for American consumers, especially young and first-time homebuyers, with nearly 39 percent of Gen Z hopefuls citing saving for a down payment as their greatest obstacle. While down payments are often the focal point of surveys and discussions, their role should not obscure the significant challenges posed by closing costs. Closing costs can be substantial—potentially amounting to a hefty percentage of the purchase price—and can be as much of a barrier to homeownership as down payments.” See https://www.jpmorganchase.com/institute/research/household-debt/hidden-costs-of-homeownership-race-income-and-lender-differences-in-loan-closing-costs.
[3] These costs exclude things like adjustments for prepaid real estate taxes, the value of fuel oil in the house’s storage tank, etc. Rather, they only include closing costs where some organization – a vendor – is providing a service that is paid for at closing.
[4] According to Rocket Mortgage, one of the largest mortgage originators, closing costs for buyers will be from 3 to 6 percent of the mortgage amount. According to Bankrate, a leading financial website, they will range from 2 to 5 percent of the mortgage amount. To adjust for non-vendor items that may be included in these estimates, the upper end of the range has been reduced by 1 percentage point, so these will become 3 to 5 percent and 2 to 4 percent, respectively. Combining them into a single range of 2 to 5 percent for buyer-paid costs, plus seller-paid costs of at least 5 to 6 percent, produces a range of at least 7 to 11 percent in total.
[5] See National Association of Realtors (NAR) 2023 Profile of Home Buyers and Sellers. https://store.realtor/2023-nar-profile-of-home-buyers-and-sellers-download/. (Behind a paywall.) The ten-year average from 2014 to 2023 was 6.4 percent. A non-paywalled summary can be found at: https://www.nar.realtor/research-and-statistics/research-reports/highlights-from-the-profile-of-home-buyers-and-sellers. In both documents, see the section titled “Financing the Home Purchase.”
[6] Prior to the Great Financial Crisis, this effort was not successful, as the loans were often of substandard quality. Of note, during the height of the bubble (2005 and 2006), the average downpayment by an FTHB actually decreased to just two percent. Post-2008, with all the reforms enacted via the Dodd-Frank Act (e.g., requiring a proper ability-to-repay analysis, withholding certain legal protections from mortgage products considered potentially abusive, etc.), lower downpayment loans (sometimes down to 3 or 3.5 percent) are being offered via the government mortgage agencies (e.g., Fannie Mae, Freddie Mac, etc.) without seeming excessive credit risk.
[7] An article referencing how long-lasting this focus has been can be found at https://www.axios.com/2024/03/21/doj-nar-settlement-home-buying.
[8] A non-expert-friendly summary of the settlement can be found at https://www.nerdwallet.com/article/mortgages/what-nar-settlement-means-for-home-buyers-sellers.
[9] See the DOJ “backgrounder”: https://www.justice.gov/opa/press-release/file/1338606/dl.
[10] See https://thehill.com/regulation/court-battles/4577716-court-grants-doj-authority-to-reopen-realtors-probe/.
[11] In terms of making homeownership as affordable as sustainably possible, many point out that the settlement might make the closing costs for the buyer higher, not lower, as at this time buyers do not overtly pay anything. There are many viewpoints about how the underlying economics works. For example, is the house price marked up so the seller is compensated for paying the buyer’s broker? This issue has many possible outcomes, and it is beyond the scope of this paper to examine them.
[12] This includes the usually smaller cost of owner’s title insurance.
[13] A $300,000 purchase price with a 5 percent downpayment would be $15,000. Given the many programs for under-5 percent downpayment, I estimated $10,000 as being the lower bound of a range for FTHB buyers, although less is certainly possible, especially in lower-priced locations.
[14] This quantitative definition of “material” is commonly used in public company reporting matters.
[15] Naturally, the title insurance industry and others benefiting from its revenues aggressively advocate that this is not true.
[16] Insurance companies invest policy premiums after they are received until the funds are needed to make payments to the policy beneficiary. This can last decades for life insurance, but only a year or two for auto policies.
[17] See NAIC’s “U.S. Property & Casualty and Title Insurance Industries – 2021 Full Year Results,” Page 15. https://content.naic.org/sites/default/files/inline-files/2021%20Annual%20Property%20%26%20Casualty%20and%20Title%20Insurance%20Industry%20Report.pdf.
[18] See https://www.gao.gov/products/gao-07-401.
[19] The GAO report’s introduction, states: “Consumers find it difficult to comparison shop for title insurance because it is an unfamiliar and small part of a larger transaction that most consumers do not want to disrupt or delay for comparatively small potential savings.”
[20] There is a history of third-party selection in various parts of the mortgage business going to extremes, sometimes reaching the point of being ruled illegal. This is accompanied by a long history of cat and mouse between the industry and the government, as has existed with respect to real estate brokers and the NAR, over what is or is not an unacceptable fair dealing practice, but with mixed success. A recent example of this dynamic concerns joint ventures. See, for example, https://www.consumerfinsights.com/2023/07/real-estate-agents-joint-ventures-cfpb-policy/ and https://www.alta.org/file?name=ALTA-Insights-JV-or-Not-to-JV.
[21] And many states have established state-set title policy costs to help alleviate the problem. Unfortunately, their cost levels (with the exception of Iowa) are not all that low. Examining several (e.g. Connecticut), they seem to be only at the low end of the cited 0.50 to 1.00 percent range.
[22] For an explanation of “rent-seeking,” a term borrowed from economics, see https://www.investopedia.com/terms/r/rentseeking.asp.
[23] For more on the interesting Iowa exception, see https://lawreviewdrake.files.wordpress.com/2015/04/strickler_note.pdf. The reasons cited for Iowa moving towards its state-run title company are exactly the same ones that exist today in the other 49 states, i.e., overpriced policies when compared to the actual history of losses.
[24] There is a significant history of government units underpricing risk, which results in large losses and the need for bailouts. A good recent example of this is the National Flood Insurance Program. See https://heritageaction.com/scorecard/votes/h566-2018.
[25] See Iowa’s title insurance cost calculator: https://cap.iowatitleguaranty.com/Public/PremiumCalculator.aspx.
