Buying a home is more complex than most purchases. Most buyers know they need a down payment and closing costs, but there are other fees and expenses, too.
One to expect at the closing table is mortgage prepaid items, also known as prepaid costs. Lenders are legally required to disclose these additional costs in the mortgage documents.
But not every homebuyer scrutinizes mortgage payment estimates. So you might be surprised at these extra expenses at the last moment. No one likes to be surprised by a big bill at the closing table.
No worries! Mashvisor is here to reduce your home buying stress. With this guide on What Prepaid Costs Are When Buying A Home, you’ll walk into your home closing with all the information you need.
Prepaid Costs Definition
Prepaid costs when purchasing a home may include:
- Escrow deposit
- Initial homeowner’s insurance premium
- Mortgage interest
- Real estate property taxes
Remember, prepaid costs are separate from closing costs. Each prepaid fee will be described in the mortgage loan estimate.
You receive this document after the mortgage company approves you for the mortgage. The lender is required by law to provide the mortgage loan estimate as part of the underwriting process.
The borrower pays prepaid costs upfront before making the down payment on the mortgage. These costs are paid at the closing table and deposited into an escrow account (we explain everything about escrow accounts below). Prepaid fees pay for mortgage expenses before closing.
Prepaid costs are usually included in the total monthly mortgage payment. But you pay these in advance at closing before you make your first monthly mortgage payment.
You might notice that you don’t have an initial mortgage payment for the first month of the loan. That’s because you already paid it in your closing costs. Usually, the first mortgage payment is due 30 days after the loan closes.
Prepaid Costs That Are In Your Mortgage
Let’s look closer at what are prepaid costs when buying a home. Understanding these fees ensures you know how every dollar is spent.
Expenses that should be included on your mortgage loan estimate are:
At closing, the lender usually collects one year of homeowners insurance premiums. Then the lender pays the insurer. Most mortgage lenders require the borrower to have homeowners insurance to obtain a mortgage.
You need to cover prepaid property taxes at closing. Most lenders want two months of real estate taxes in advance at closing. Taking these funds in advance lets them create a reserve for when the taxes are due.
Your property tax payment is part of the escrow deposit you make when taking out the loan. The lender makes the real estate tax payments to your city or county government from the escrow account.
Most mortgage payments are made on the first of the month. However, if you close the loan on any day other than the first, the lender will want prepaid mortgage interest. This payment will be placed in your escrow account and applied to the initial mortgage payment.
How much prepaid interest do you pay? The amount is calculated from the closing date through the month’s end. The per-day interest cost is also called ‘per diem.’ This amount is multiplied by the number of days left in the month.
Remember: Prepaid interest is determined by how many days between closing and the end of the month. So cut the amount of money you need at closing by setting the closing date at the end of the month.
You can save hundreds of dollars in closing costs by setting the closing date on the 30th instead of the 1st.
Initial Escrow Deposit
Some lenders want a cushion built into your escrow account. So, the lender may want you to pay an initial escrow deposit when you close the loan. The initial escrow payment typically includes two months of homeowners insurance. This is over and above the homeowner’s insurance premium paid at closing.
Two months of real estate property taxes are also part of the prepaid escrow deposit. The extra cash in the escrow account ensures there are sufficient funds when payments are due.
The lender will put your homeowner’s insurance and property taxes in the escrow account when you make mortgage payments. These are collected with your mortgage payment monthly. They’re paid in addition to the mortgage loan and interest.
Escrow Account Overview
What’s this about an escrow account, you say? When a lender offers a loan for an expensive item – such as that $300,000 home in Las Vegas you want – it wants assurance their investment is protected.
The lender does this in two ways. First, it ensures the property tax bill is paid, so the local government doesn’t put a lien on the home.
Second, it makes sure the homeowner’s insurance premium is covered. The last thing the lender wants is to loan you $300,000. Then, the property burns down the next day, and you don’t have insurance. That’s what the lender wants to avoid.
This is where the escrow account comes in. The escrow account, also called an impound account, protects the lender. But it also offers protection to the homeowner.
A portion of the real estate tax and homeowner’s insurance bill is paid every month. So, you pay for these essential items over 12 months and not all at once. Most homeowners don’t want a giant tax or insurance bill every December.
The lender sets up the escrow account when the loan closing date is set. The account needs to be funded. And that’s done with your prepaid costs.
Prepaid Costs vs. Closing Costs
Now that you know what prepaid costs are when buying a home, what about closing costs?
Closing costs are what you pay the mortgage lender and various third parties for processing and overseeing the loan. Your closing disclosure statement provides details of each closing cost.
Some closing costs you may pay are:
This amount is charged by the real estate lawyer to draw up and review the purchase agreement and contract. However, not every state requires an attorney to handle the home purchase.
You need a current property appraisal as part of the mortgage process. The assessment is done by a licensed professional who assess the home’s value.
The appraisal includes a property inspection, a comparison to similar homes in the community, and the final appraisal report.
Title Fees And Title Insurance
The title refers to the right to own and use the property you purchase. Title fees pay the title company to review, adjust and insure the title of the home.
The title company performs a title search to see any liens or encumbrances. Then, the title company can make any needed changes.
The lender must know there are no liens or encumbrances on the property to protect their investment. It also helps you understand that the property has no strings attached that could trip you up later.
Government Fees And Taxes
There are sales taxes when you buy the home. Also, the city or county may charge a fee for a property inspection before you take ownership.
The home seller might pay some of your closing costs, depending on how you negotiate the purchase. But you will always need to cover prepaid costs at the closing table.
How Do You Calculate Prepaid Costs?
It’s essential to know your prepaid costs before closing on your home. Knowing precisely what you’ll need to pay will help you budget moving forward.
As we noted earlier, prepaid costs include:
- 12 months of homeowners insurance payments, and two months additional for escrow reserves
- Two months of real estate property taxes set by your city government. For instance, if your yearly tax bill is $10,000, you would prepay $2,000 into the escrow account.
- Any mortgage interest that accrues from the closing date through month’s end. Remember, you can pay less in upfront mortgage interest by closing at the end of the month.
Prepaid costs are stated on Page 2, Section F of your mortgage loan estimate document under ‘Prepaids.’ Also, look at Section G, called ‘Initial Escrow Payment At Closing.’
Your lender is required to provide you with this estimate before the loan closes. If you didn’t get this document, talk to your lender immediately.
How To Save On Prepaid And Closing Costs
Prepaid and closing costs can add up to thousands of dollars. But the good news is that you might be able to reduce the sum by shopping around between lenders and third-party service providers.
However, note that some costs can be negotiated but some can’t.
As you probably know, you can’t negotiate on property taxes. However, feel free to check with several lenders to see which offers the lowest mortgage rates.
The same applies to homeowners insurance. With some shopping, you may find a lower premium. You also can check for an insurance bundle deal that offers a lower premium for your homeowners and auto insurance.
Are you paying 20% down or more for a conventional loan? Ask the lender to waive your escrow requirement. But if this is waived, you’re responsible for paying property taxes and insurance on time.
Most homeowners prefer the escrow account, so they’re certain insurance and property tax expenses are covered.
Your loan estimate document has ‘Services You Can Shop For” and ‘Services You Cannot Shop For.’
You can save money at closing by shopping for third-party service providers, such as surveyors and title companies. That way, you can get the best price for these essential services. And your lender must give you a list of businesses that offer the services.
Also, if cash is tight, consider a no closing cost mortgage loan. A loan with no closing costs has a slightly higher mortgage rate to compensate the lender for these fees. You need to weigh whether it’s better to pay closing costs up front or over time.
Services you can’t shop for are selected and required by the mortgage lender. Compare what these items cost with other lender estimates so you get the best deal.
Calculating Prepaid Costs
We’ve covered what are prepaid costs when buying a home. Now let’s dive into a few examples to illustrate how to determine your prepaid costs.
Let’s say you want to estimate what your homeowner’s insurance will cost for 12 months. Insurance premiums vary based on location, age and home condition, payment history, and credit score.
Home insurance rates might be higher if your area is prone to flood or other natural disasters. But the premium may be lower if you expand the family room or put in a metal roof.
Homeowner’s insurance premiums average about $1,250 in the US. But some states charge more than others.
Remember to talk to an insurance agent in your state so you get an accurate picture of your annual insurance cost. You’ll pay the insurance premium through the escrow account when you make your monthly mortgage payment.
Real Estate Taxes
Say you want to determine what your annual property tax bill will be for your new home. To calculate this number, multiply your home’s assessed value by the local tax rate.
For example, if your property tax is 3% and the home’s assessed value is $200,000, your property tax bill for the year is $6,000. Divide that by 12, and you will pay $500 per month for property taxes in your mortgage payment.
Prepaid costs when buying a home can sneak up on you at closing time if you don’t pay attention. But now, you have a thorough understanding of prepaid costs and where to find them on your mortgage estimate documents.
As you travel through your home buying journey, don’t get nervous about mortgage prepaids or other aspects of the closing process.
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