What Are Prepaid Costs When Buying a Home?
Beyond the down payment, there are other costs at closing. Discover what prepaid expenses are and how they set up the financial foundation for your new home.
When purchasing a home, buyers encounter various expenses at closing. Among these are prepaid costs, which are fundamentally different from other closing-day payments. These are expenses related to owning the home that are paid in advance, rather than fees for services to complete the transaction. By paying these items upfront, you are setting up the necessary accounts and coverages that will protect you and your lender from the moment you take ownership.
Differentiating Prepaids from Other Closing Expenses
The three main types of cash due at closing are the down payment, closing costs, and prepaid costs. The down payment represents your initial equity stake in the property, directly reducing the principal amount of your mortgage loan.
Closing costs are fees paid to the various parties who provided services to facilitate and finalize the real estate transaction. These can include lender origination fees, appraisal fees, title search fees, and attorney charges. These payments compensate professionals for work performed to approve your loan and legally transfer the property title.
Prepaid costs cover future, recurring expenses associated with owning the property. Unlike closing costs, which are one-time fees for the transaction, prepaids are for items like property taxes and homeowners insurance that you will continue to pay. Your lender requires these to be paid in advance at closing to create a financial cushion for your new home’s ongoing expenses.
Common Types of Prepaid Costs
Homeowners Insurance Premium
Lenders have a financial interest in your property and require it to be protected against damage from events like fire, theft, or natural disasters. To ensure this protection is in place from the moment the sale is final, they mandate that you pay the first full year’s homeowners insurance premium at or before closing. This payment is a common prepaid cost. The cost of this premium can vary widely based on the home’s value, location, and the level of coverage selected.
Property Taxes
Lenders also require prepaid property taxes to ensure they are paid on time and avoid tax liens on the property. At closing, your lender will collect a certain number of months’ worth of property taxes as a prepaid item. The specific amount collected depends on your closing date and the property tax cycle in the local jurisdiction. For example, if taxes are due semi-annually and you close two months before a payment is due, the lender will collect enough to cover that upcoming bill plus an additional cushion.
Per Diem Mortgage Interest
Your first regular mortgage payment is due on the first day of the month following the month after you close. For instance, if you close on May 15th, your first full mortgage payment will be due on July 1st. However, interest on your loan begins to accrue immediately from the day of closing. Per diem interest, also known as interim interest, is a prepaid cost that covers the interest on your loan for the period between your closing date and the end of that month. In the May 15th example, you would prepay the interest for the remaining days of May at the closing table, which ensures all interest is paid before your first standard payment cycle begins.
Locating Prepaids on Your Loan Documents
The TILA-RESPA Integrated Disclosure (TRID) rule mandates the use of standardized forms to help borrowers understand their loan terms. You can find a detailed breakdown of your prepaid costs on two documents: the Loan Estimate and the Closing Disclosure. The Loan Estimate, which you receive within three business days of applying for a mortgage, provides an initial projection of these costs.
You will find these figures itemized in “Section F. Prepaids” of the Loan Estimate. This section lists the homeowners insurance premium, property taxes, and any prepaid interest, along with their estimated amounts. As you approach your closing date, you will receive the Closing Disclosure form at least three business days before you are scheduled to sign the final paperwork. This document provides the final, confirmed figures for your loan, allowing you to compare the final amounts to the initial estimates.
The Role of an Escrow Account
The prepaid amounts for homeowners insurance and property taxes collected at closing are used to fund your escrow account, also called an impound account. An escrow account is a special savings account managed by your mortgage lender or servicer. The initial payments you make at closing provide the starting balance for this account.
Each month, your total mortgage payment, often referred to as PITI, will include not just principal and interest on the loan, but also a portion for taxes and insurance. This is one-twelfth of your annual property tax bill and one-twelfth of your annual homeowners insurance premium. Your lender deposits this portion of your monthly payment into the escrow account. When the tax and insurance bills come due, the lender uses the funds accumulated in the escrow account to pay them on your behalf. This system prevents large, unexpected bills and ensures no lapses in insurance coverage or delinquent tax payments.