What Are Prepaid Costs When Buying a Home?
Unpack the concept of prepaid costs in home buying. Understand these essential upfront expenses that contribute to your closing total.
When purchasing a home, financial obligations arise at closing that extend beyond the property’s purchase price. Prepaid costs are payments made upfront for services or obligations that will continue to benefit the homeowner beyond the closing date.
What Are Prepaid Costs
Prepaid costs are payments made at the time of closing for upcoming expenses related to homeownership. The fundamental reason these costs are “prepaid” is to ensure continuity of coverage or payment obligations for a period extending past the closing date. This means funds are collected in advance to cover items like property taxes or insurance premiums that will come due shortly after you take possession of the home. These costs differ from other closing costs, which typically cover one-time transaction fees for services rendered to process the loan and transfer the property. Prepaid costs, in contrast, are for expenses that will recur periodically throughout homeownership, such as annual insurance premiums or property tax installments.
Key Prepaid Expenses
Several common types of prepaid expenses are encountered during a home purchase.
Prepaid Property Taxes
Prepaid property taxes often constitute a portion of the funds collected at closing. Buyers usually prepay these taxes to cover the period between the closing date and the next scheduled tax due date. These amounts are frequently prorated, meaning the buyer pays only for the days they will own the property within a specific tax period.
Homeowner’s Insurance Premium
The first year’s homeowner’s insurance premium is typically paid in full at closing. This upfront payment ensures the property is insured from the moment ownership transfers, protecting both the homeowner’s and the lender’s investment. Lenders typically require this to safeguard their collateral.
Prepaid Mortgage Interest
Prepaid mortgage interest, also known as per diem interest, covers the interest that accrues on the mortgage loan from the closing date up to the last day of the month. This per diem payment bridges the gap until the first full mortgage payment, which covers interest for the following month. For instance, if closing is on June 10th, you would prepay interest for June 10th through June 30th.
Initial Escrow Account Funding
Lenders often require an initial deposit into an escrow account at closing. This initial escrow account funding establishes a starting balance for the lender to pay future property tax and homeowner’s insurance bills on the homeowner’s behalf. This initial deposit typically ranges from two to six months’ worth of these recurring expenses, ensuring sufficient funds are available when payments are due.
Calculating and Paying Prepaid Costs
The process for estimating, disclosing, and paying prepaid costs is standardized to provide transparency to the homebuyer.
Loan Estimate
Lenders provide an estimate of these costs early in the mortgage application process on a document called the Loan Estimate. This form outlines important details about the loan, including projected payments and various closing costs, allowing buyers to anticipate financial requirements.
Closing Disclosure
The final, itemized breakdown of all prepaid costs is presented on the Closing Disclosure document, which borrowers typically receive at least three business days before the scheduled closing date. This document provides a clear summary of all transaction costs, and reviewing it carefully is important to ensure accuracy and avoid surprises. Buyers should compare the Closing Disclosure with the initial Loan Estimate to identify any significant changes.
Payment at Closing
Prepaid costs are typically paid as part of the total cash to close, due at closing via wire transfer or certified check. These funds are then placed into an escrow account managed by the lender, to be disbursed when the property taxes and insurance premiums become due.
Post-Closing Escrow Management
After closing, if an escrow account was established, the lender collects a portion of these costs with each monthly mortgage payment. This ongoing collection allows the lender to accumulate funds to pay future property tax and homeowner’s insurance bills as they come due, simplifying financial management for the homeowner. The lender manages the disbursements from this account, ensuring timely payments of these recurring obligations.