Do You Have to Pay Prepaids at Closing?

When purchasing a home, buyers encounter various financial obligations beyond the agreed-upon price. These often include closing costs, which are fees for services related to the loan and property transfer, and a distinct category known as prepaids. Prepaids are an important part of the total funds due at closing, covering expenses that extend beyond the transaction date itself. Understanding prepaids is essential for prospective homeowners to prepare for their home purchase.

Understanding Prepaid Expenses

Prepaid expenses in real estate refer to costs paid at closing that cover future services or obligations. These are distinct from the one-time fees associated with the loan’s origination or the property’s transfer. Rather, prepaids are advance payments for recurring costs that accrue shortly after purchase, ensuring essential services and obligations are covered from day one. Lenders often require these payments to protect their investment, ensuring the property remains insured and taxes are current. Prepaids provide a buffer for expenses like property taxes and insurance premiums, typically due at specific intervals.

Common Items Included in Prepaids

Several types of expenses are commonly categorized as prepaids during a real estate transaction. Property taxes are a frequent inclusion, as buyers often pay a portion upfront to cover the period from closing until the next tax bill is due. This is necessary because tax cycles rarely align perfectly with closing dates, requiring an adjustment between the buyer and seller.

Homeowners insurance premiums are a significant prepaid expense, with the first year’s premium typically paid in full at closing. Lenders mandate this to protect the property, which serves as collateral for the mortgage loan.

Another common prepaid item is “per diem interest,” covering mortgage interest accrued from closing through the end of that month. Since the first full mortgage payment is usually due on the first day of the second month following closing, this prepaid interest bridges the gap. If the property is part of a homeowners association, a portion of HOA dues (e.g., one month or a quarter) might be required as a prepaid expense, especially if the association bills in advance.

How Prepaid Amounts Are Determined

Prepaid amounts are calculated using established real estate practices. Property taxes and, at times, homeowners association dues are prorated between the buyer and seller based on the closing date. This proration ensures that each party pays only for the days they own the property within a given billing cycle, with the buyer often reimbursing the seller for any taxes or dues the seller has already paid for a period extending beyond the closing.

A portion of prepaids involves setting up an escrow account. Lenders typically require an initial deposit into this account to cover future property taxes and homeowners insurance premiums. This deposit usually includes a “cushion,” often two months’ worth of payments, beyond what is immediately due. This cushion provides a buffer against unexpected increases in tax assessments or insurance premiums. The number of months for this escrow cushion is determined by the lender, often adhering to regulatory guidelines like the Real Estate Settlement Procedures Act (RESPA), which generally limits the cushion to one-sixth of estimated annual disbursements.

Paying Prepaids at Closing

Prepaid expenses are collected as part of the total cash due at closing, alongside the down payment and other closing costs. This ensures that, from property transfer, necessary funds are in place for ongoing obligations. Lenders require these upfront payments to protect their interest in the property by ensuring continuous insurance coverage and prompt property tax payments, mitigating risks like uninsured losses or tax liens.

Funds collected for future property taxes and insurance premiums are deposited into the established escrow account. From this account, the mortgage servicer will disburse payments on the homeowner’s behalf as bills come due. All prepaid amounts, along with other transaction details, are itemized on the Closing Disclosure form, which borrowers should review at least three business days before closing. This transparency allows buyers to understand what they are paying for and how funds are allocated to cover initial and ongoing homeownership costs.