What Are Prepaids in a Mortgage at Closing?

Mortgage prepaids are funds collected at the closing of a home loan to cover specific expenses related to homeownership. These amounts are paid in advance to ensure property-related costs are covered from the moment you become the homeowner. Prepaids represent a significant part of the total cash needed at closing, beyond the down payment, and understanding them helps in accurately budgeting for a home purchase.

Defining Mortgage Prepaids

Mortgage prepaids are expenses paid upfront at closing to cover initial periods of various homeownership costs or establish an escrow account. Unlike other closing costs, which are typically one-time fees for services like loan origination or appraisal, prepaids are ongoing expenses paid ahead of their due date.

Lenders require prepaids to protect their investment in the property. By collecting funds for items like property taxes and insurance premiums at closing, lenders ensure these expenses are covered from the start of homeownership. This safeguards the property against tax liens or uninsured damages, which could jeopardize the lender’s interest.

Key Components of Mortgage Prepaids

Mortgage prepaids collected at closing commonly include property taxes, homeowner’s insurance premiums, mortgage insurance premiums (if applicable), per diem interest, and initial escrow account reserves. Each component serves a distinct purpose in securing ongoing financial obligations of homeownership.

Property taxes are annual fees homeowners pay to local governments, supporting public services. Lenders typically require a certain number of months of estimated property taxes to be paid upfront at closing. This initial collection helps fund an escrow account or covers the period until the next tax bill is due, ensuring continuous coverage.

Homeowner’s insurance premiums are another common prepaid expense. Lenders mandate that the first year’s premium for homeowner’s insurance is paid in full at or before closing. This ensures the property is insured against damage from day one, protecting both the homeowner’s and the lender’s financial interests. In addition to the first year’s premium, lenders may collect an additional two to three months of insurance premiums to be held in the escrow account as a reserve.

Mortgage insurance premiums (MIP or PMI) may also be collected at closing, depending on the loan type and down payment. For instance, Federal Housing Administration (FHA) loans typically require an upfront mortgage insurance premium (UFMIP), which is often paid at closing. Private Mortgage Insurance (PMI) for conventional loans, usually required when the down payment is less than 20%, is most commonly paid monthly, though a portion might be collected upfront at closing.

Per diem interest, also known as prepaid interest, is the interest that accrues on the mortgage loan from the closing date to the end of the current month. Since mortgage interest is paid in arrears, this upfront payment covers the gap between closing and the first full monthly payment cycle. For example, if you close on the 15th of a 30-day month, you would pay 15 days of interest at closing.

An initial escrow account cushion or reserve is often collected. This buffer, typically equivalent to two months of estimated property taxes and homeowner’s insurance payments, is held in the escrow account. The cushion ensures sufficient funds to cover potential increases in tax or insurance costs, or unexpected disbursements, without causing a shortage.

Handling and Payment of Mortgage Prepaids

Mortgage prepaids are typically collected at closing as part of the total cash due from the homebuyer. These funds are not paid directly to service providers at that moment, but are managed by the lender or a third-party escrow agent. This ensures future expenses are accounted for and secured from the outset of homeownership.

The primary mechanism for managing ongoing prepaid expenses like property taxes and homeowner’s insurance is the escrow account. When you pay your initial prepaids at closing, a significant portion of these funds is deposited into this escrow account. This initial deposit establishes the necessary balance to cover upcoming bills.

Following closing, your regular monthly mortgage payments will include an additional amount for the escrow account. This monthly contribution replenishes the funds, allowing the lender to pay your property tax bills and insurance premiums when due. The lender acts as a fiduciary, using the escrowed funds to make timely payments on your behalf.

While most ongoing prepaids are managed through an escrow account, some items, such as the first year’s homeowner’s insurance premium, are often paid directly to the insurance company at closing. Per diem interest is also paid at closing to cover the current month’s interest. The distinction lies in whether the funds are held in an account for future, recurring payments or are used for an immediate, one-time or short-term expense.

Financial Impact of Mortgage Prepaids

Mortgage prepaids significantly contribute to the total cash outlay required at closing. While homebuyers often focus on the down payment and loan-related closing costs, prepaids represent a separate, substantial amount that must be paid upfront.

The total cost of prepaids can vary widely, potentially ranging from a few thousand dollars to $10,000 or more, depending on the property’s value, location, and closing timing. Although prepaids increase the upfront financial burden, they cover expenses that would eventually be due regardless of the mortgage transaction. You are prepaying for obligations inherent to owning a home.

The itemization of prepaids is clearly presented on the Closing Disclosure (CD) document, specifically in Section F, titled “Prepaids.” This document, which borrowers receive at least three business days before closing, provides a detailed breakdown of all costs associated with the loan, including the amounts for each prepaid item. Reviewing this section helps homebuyers understand precisely what these funds cover and how they factor into the final cash needed to close.