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Buying a home is an exciting milestone, but it also involves numerous additional fees and costs. While most homebuyers are prepared to cover the down payment and closing costs, many are surprised by the prepaid costs, also known as “prepaids,” that come with a mortgage loan.
In this comprehensive guide, I will explain what exactly prepaids are, the different types of prepaids, how to calculate them, and how they differ from closing costs. My goal is to provide homebuyers with a clear understanding of prepaids so you know what to expect when applying for a mortgage loan.
What Are Prepaids on a Mortgage Loan?
Prepaids are costs paid at closing that cover future housing expenses over the first few months of homeownership. Since homeowners often pay bills like property taxes and insurance annually or semi-annually, lenders require an upfront cushion to cover these payments when they come due.
Here are some common prepaid costs on a mortgage:
- Homeowner’s insurance premiums
- Property taxes
- Mortgage interest
- Initial escrow deposit
While prepaids are paid upfront at closing, they differ from closing costs and escrow Closing costs are lender fees for processing the loan, while escrow refers to the special account where the prepaid funds are held until needed
Why Do Lenders Require Prepaids?
Lenders want to ensure homeowners have enough funds set aside to make important property tax and insurance payments on time. By collecting prepaids upfront, lenders are protecting themselves and the homebuyer.
If a homeowner misses a tax or insurance payment, the lender is at risk. Requiring prepaid costs prevents this issue by setting aside a cash reserve for future bills. This approach provides a buffer in case the homeowner faces financial hardship down the line.
While prepaids provide important financial safeguards, they also increase upfront costs for homebuyers at closing. Understanding exactly what prepaids entail and budgeting for them is key to avoiding surprises.
Types of Prepaid Costs on a Mortgage
Let’s take a closer look at the most common prepaid costs lenders require and what they cover.
Prepaid Homeowner’s Insurance
Most lenders require one year of homeowner’s insurance premiums to be paid upfront at closing. This prepay covers the homebuyer from when they purchase the home until the policy renewal date, usually 12 months later.
At closing, the homebuyer only pays the prorated amount owed from the time of purchase until the end of the current policy period. This ensures insurance coverage is paid ahead.
Prepaid Property Taxes
Property tax prepayments cover the remaining taxes owed by the seller from their last payment until the end of the tax year. As with insurance, the lender prorates this amount so the buyer only pays taxes for the portion they occupy the home.
Lenders require property tax prepaids to ensure taxes don’t become delinquent. In some cases, lenders may require prepayment of supplemental taxes that kick in after a home sale.
Prepaid Mortgage Interest
Depending on when you close, you may need to prepay interest on your mortgage loan for the first 30 days until your first mortgage payment is due.
For example, if you close on the 10th of the month, you would prepay interest for days 10-30 when no mortgage payment is yet collected. This ensures interest doesn’t accrue unpaid.
Initial Escrow Deposit
On top of prepaid insurance and taxes, most lenders require an initial deposit into your escrow account. This extra cushion ranges from 2-6 months of escrow payments.
The deposit prevents the account from falling short on future payments if insurance or taxes increase. It also covers months where multiple payments are due before enough funds accrue via your monthly mortgage payment.
How to Calculate Prepaids
Calculating estimated prepaids helps homebuyers budget and avoid surprises later:
Homeowner’s Insurance: Get a home insurance quote for the property and multiply by 12 months
Property Taxes: Multiply assessed home value by local tax rate
Mortgage Interest: Multiply [loan amount] by [daily interest rate] by [number of days from closing to 1st payment]
Initial Escrow: Check lender requirements, often 2 extra mortgage payments
While estimated prepaids help set expectations, the lender ultimately determines the required amounts based on factors like loan date, tax due dates, policy renewal dates, and escrow analysis.
Prepaid Costs vs. Closing Costs
Prepaid costs differ from closing costs, though both are paid at closing. Closing costs are lender fees and third-party charges to process the mortgage loan. Common fees include:
- Origination charges
- Appraisal fees
- Credit report charges
- Title fees
- Recording fees
While the seller can pay some closing fees, the buyer always covers prepaids. Prepaids go into escrow for future costs, while closing costs are administrative charges that don’t carry over.
It’s key to understand how prepaids differ from closing fees, so you know what to budget for. Getting fee estimates from your lender early on helps avoid surprises.
Where to Find Prepaids on Your Loan Estimate
After applying for a mortgage, you’ll receive a Loan Estimate from the lender outlining estimated terms and costs. Prepaids are typically listed under “Other Costs” or “Initial Escrow Payment” on page 2.
Review the Loan Estimate closely to ensure you see and understand all prepaid fees. Ask your lender to explain any unclear charges. Remember, the Loan Estimate provides preliminary estimates – the final prepaid amounts will be on your Closing Disclosure.
Prepaid Costs at Closing
Just before closing, the lender sends a Closing Disclosure outlining your final loan costs. Verify that the prepaid amounts match your expectations and the estimates provided.
While total prepaids are typically close to initial estimates, discrepancies can happen, for example if your policy renewal or tax payment dates shifted. Ask your lender to explain any changes in prepaids between the Loan Estimate and Closing Disclosure.
At closing, prepaid costs are paid from your down payment funds or closing costs. You’ll sign an agreement authorizing the lender to disburse prepaid funds into escrow.
Can I Avoid Prepaids?
Prepaid costs are a standard requirement for most mortgage loans. However, some lenders may offer alternatives or waivers if a borrower meets certain criteria, such as:
- Significant assets/reserves
- Strong credit history
- Low debt-to-income ratio
- Large down payment
Ask your lender if they ever waive prepaids for qualified borrowers. For example, some may waive mortgage interest prepayment for borrowers with funds to cover it outside of escrow.
While waivers are rare, be sure to inquire – avoiding even one large prepaid could help minimize your closing costs.
What Happens After Closing?
Once you close and pay prepaids, here is what happens next:
- Funds go into your escrow account with the lender
- Monthly mortgage payments contribute additional escrow deposits
- When premiums or taxes are due, funds disburse from the escrow account
- You receive statements showing escrow account activity and balance
New escrow analyses occur annually to confirm there are sufficient prepaid reserves. If short, your monthly payment may increase to replenish the account.
If you pay off your mortgage early, you may receive a refund of unused escrow funds, including any remaining prepaid deposits. This refund can lower your payoff amount.
Key Takeaways
Prepaids are upfront costs homebuyers pay at closing to cover future bills like property taxes and homeowner’s insurance. While required by most lenders, prepaids ensure financial safeguards are in place.
Knowing what prepaids entail and budgeting for them is crucial to avoid closing surprises. Be sure to review your Loan Estimate and ask your lender questions to clarify any unclear prepaid fees.
While closing day can feel overwhelming, understanding prepaid costs in advance helps you feel informed and empowered as you finalize your mortgage loan. With the key details covered in this guide, you can move forward confidently into homeownership.
How to calculate prepaids
Your prepaid expenses are calculated on the closing disclosure that you’ll receive from your lender three business days before the closing takes place. Find them on Page 2, Section F of the document, alongside closing cost details. They will consist of:
- Six to 12 months of homeowners insurance premiums, plus two months for escrow reserves.
- Two months of property taxes as set by your local government (for example, if your annual property tax bill is $12,000, you’d prepay $2,000 into an escrow account).
- Any interest that accrues on the loan from the closing date through the end of the month.
Prepaid costs when buying a home
Mortgage prepaids, sometimes referred to simply as prepaids, are upfront payments a homebuyer makes to cover certain expenses in advance, before they’re actually due. Prepaids commonly include monthly homeownership expenses like homeowners insurance premiums and property taxes.
Because they’re payable at closing, they are sometimes rolled into the umbrella term “closing costs” — but there’s a fundamental difference. Rather than paying the vendor or provider directly, your lender will park prepaid funds in an escrow account, from which they will distribute payments as needed. Common prepaids include:
If you close on any day other than the first of the month — the day most mortgage payments are due — your mortgage lender will collect prepaid mortgage interest at the closing. It will be placed in an escrow account to be applied to your first mortgage payment.
The amount of prepaid interest you pay is calculated from the date of closing through the end of the month. This amount is your per-day (or “per diem”) interest cost on the loan multiplied by the number of days left in the month.
Keep in mind that because your prepaid interest is based on the number of days between your closing and the last day of the month, you can lower the amount of money you’ll need to bring to closing by scheduling the closing date near month’s end.
Generally, lenders require borrowers to obtain a homeowners insurance policy in order to secure a mortgage. At the typical closing, a mortgage lender collects six to 12 months of homeowners insurance premiums, which it will distribute to your insurer each month.
Mortgage lenders also estimate how much property tax you’ll owe in advance. They typically ask for two months of property taxes upfront at the closing to build a reserve for when those payments come due. This money will be part of your initial escrow deposit (more on that below). From your escrow account, the lender will then make the property tax payments to your local government on your behalf.
To help create a cushion in your escrow account, your lender might also require an initial escrow payment at closing. This usually consists of two months of homeowners insurance, over and above whatever premium you pay at closing. Your two months of property taxes are also part of this deposit. This cash reserve helps ensure there is enough money available to pay those bills when they are due.
Once your mortgage payments kick in, your lender will continue to hold your monthly home insurance and property tax payments in escrow. Note that these are collected with your mortgage payment in addition to the loan principal and interest.
What Are PREPAID COSTS When Buying A Home?
FAQ
What is a prepaid mortgage loan?
What are the prepaid items on a closing statement?
How do prepaids work at closing?
What is the difference between mortgage prepaids and escrow?
What are prepaid costs on a mortgage loan?
Let’s take a look at the different prepaid costs you may see on your mortgage loan documents. Homeowners insurance and taxes are two common prepaid costs in a mortgage loan. Your homeowners insurance is typically prorated and prepaid at closing, covering you from when you purchased the home to the end of the year.
What is a prepaid home loan?
Prepaids commonly include monthly homeownership expenses like homeowners insurance premiums and property taxes. Because they’re payable at closing, they are sometimes rolled into the umbrella term “closing costs” — but there’s a fundamental difference.
Do prepaid costs come with buying a new home?
When it comes to buying a new home, additional fees and costs always come with the transaction. Most home buyers expect to cover the down payment and closing costs but may not anticipate prepaid costs (or “prepaids”). Lenders break down each cost in two key documents: the Loan Estimate and the Closing Disclosure.
What are the different types of prepaid mortgage loans?
When it comes to mortgage loans, there are several different types of prepaid items, the most common are: Typically, one full year of homeowner’s insurance is collected and prepaid to your insurance company at closing. Alternatively, some homeowners choose to pay this amount prior to closing.