What Are Prepaids in Closing Costs?
Navigate the essential upfront payments for future expenses within real estate closing costs and their connection to ongoing homeownership.
Purchasing a home involves financial considerations beyond the sale price. Closing costs are fees and expenses paid at the culmination of a real estate transaction. These costs are distinct from the down payment and cover services and charges for finalizing the loan and transferring property ownership. Within closing costs, “prepaids” are funds paid in advance for certain ongoing homeownership expenses.
Understanding Prepaids
Prepaids are expenses a homeowner pays upfront at closing for obligations extending beyond the closing date. Lenders require these payments to ensure expenses, such as property taxes and insurance premiums, are covered from the moment ownership transfers. This safeguards the lender’s investment by ensuring the property remains insured and tax obligations are met.
Unlike other one-time closing costs, such as loan origination fees or appraisal fees, prepaids are recurring expenses paid for an initial period or used to establish a reserve fund. This upfront payment structure helps bridge the gap between the closing date and the first regular mortgage payment, which occurs a month or more later. Collecting these funds at closing creates a financial buffer, ensuring continuity of essential services and financial obligations.
Typical Prepaid Items
Property taxes are common prepaid expenses. These are assessed annually and often prepaid at closing to cover a portion of the current year’s taxes or to establish an initial balance in an escrow account. Depending on the local tax calendar and closing date, buyers might pay for several months of taxes upfront. Property taxes are often prorated, meaning the seller pays their share up to the closing date, and the buyer assumes responsibility from that point forward.
Homeowner’s insurance premium is another prepaid item. Lenders require the first year’s premium to be paid in full at closing. This ensures the property is immediately covered against hazards, protecting both the homeowner’s investment and the lender’s collateral. Annual homeowner’s insurance premiums can vary widely, typically ranging from $1,000 to $3,000, influenced by factors such as location, property value, and selected coverage.
Mortgage interest, or “per diem interest,” also constitutes a prepaid item. This covers interest accruing on the loan from the closing date until the first full mortgage payment due date. Since mortgage payments are made in arrears, this upfront interest ensures the lender is compensated for the period before the first scheduled payment. Other prepaids include initial private mortgage insurance (PMI) premiums if the down payment is less than 20%, or homeowner association (HOA) dues.
How Prepaid Amounts Are Determined
Prepaid amounts are calculated based on the transaction’s timing. Property tax calculation involves prorations between the buyer and seller. If taxes are paid in arrears, the seller credits the buyer for their share from the beginning of the tax year up to the closing date, ensuring the buyer has funds to pay the full bill. Conversely, if the seller has prepaid taxes beyond the closing date, the buyer reimburses the seller for the unused portion. These prorations are based on a daily calculation, considering a 365-day year.
Homeowner’s insurance premiums are collected as a full year’s payment at closing. For instance, an annual premium of $1,500 is due. This ensures continuous coverage from the day the buyer takes ownership.
Mortgage interest is calculated on a “per diem” basis from the closing date to the end of the month preceding the first full mortgage payment. To determine this, annual interest is divided by 365 (or 360) to get a daily rate, then multiplied by the number of days in this interim period. These estimated amounts for prepaids are provided to the buyer on the Loan Estimate and finalized on the Closing Disclosure, documents for transparency in the lending process.
The Role of Escrow Accounts
For many prepaid items, such as property taxes and homeowner’s insurance, funds collected at closing establish an initial balance in an escrow account. An escrow account is a separate account managed by the mortgage servicer for the homeowner. Its function is to collect and disburse funds for recurring property expenses, such as property taxes and homeowner’s insurance premiums, as they become due.
This arrangement ensures timely payments, safeguarding the lender’s interest and providing homeowner convenience. After closing, the borrower makes monthly contributions to this escrow account as part of their regular mortgage payment. These contributions ensure funds accumulate to cover annual or semi-annual tax and insurance bills. Lenders are permitted by federal regulations, such as RESPA, to maintain a “cushion” in the escrow account, often limited to two months’ worth of payments, to account for unexpected cost increases.