What Are the Prepaid Costs When Buying a Home?
Navigate the essential prepaid expenses you'll encounter when buying a home. Uncover these upfront financial obligations beyond the down payment.
When purchasing a home, buyers encounter various financial obligations beyond the sale price. Prepaid costs are distinct from the down payment and other typical closing fees. These expenses represent payments made at closing for services or coverages that extend into a future period. Understanding these upfront payments is important, as they cover expenses that will arise after the closing date.
Prepaid Property Taxes
Property taxes are a recurring expense for homeowners, and their payment at closing can vary depending on local practices. Jurisdictions may require these taxes to be paid either in advance or in arrears. At closing, buyers commonly pay a portion of property taxes that covers the period from the closing date until the next tax bill is due. Alternatively, they may be required to fund an escrow account with several months’ worth of tax payments to ensure future obligations are covered.
The concept of “prorated taxes” ensures a fair division of this expense between the buyer and seller. The seller is responsible for their share of property taxes up to the closing date, while the buyer assumes responsibility from that date forward. This means that if the seller has already paid taxes for a period extending beyond the closing date, the buyer will reimburse them for the unused portion. Conversely, if taxes are due for a period prior to closing, the seller will credit the buyer for their share.
Prepaid Homeowners Insurance
Lenders typically require a homeowners insurance policy to be in effect at closing to safeguard their investment in the property. This insurance protects against potential damage to the home. The initial year’s premium for this coverage is almost always paid in full at closing, ensuring continuous coverage for the first 12 months of homeownership.
This payment covers a future period of protection for the property. While subsequent annual premiums may be collected through an escrow account as part of the monthly mortgage payment, the initial premium must be settled upfront. Securing this policy prior to closing is essential, as lenders often require proof of insurance several days before the closing date. This helps ensure that both the homeowner and the lender are financially protected from the moment ownership transfers.
Prepaid Mortgage Interest
Mortgage interest is typically paid in arrears, meaning the interest due for a given month covers the preceding month’s period. At closing, borrowers are generally required to pay “per diem” interest. This per diem interest covers the accrued interest from the closing date through the last day of the month in which the loan closes. The purpose of this payment is to compensate the lender for the period between the loan funding and the start of the first full monthly payment cycle.
For example, if a loan closes on June 15th, the borrower will pay interest for the 16 days remaining in June. This calculation is based on the loan amount, the interest rate, and the number of days remaining in the month. Paying this per diem interest at closing ensures that the borrower’s first regular mortgage payment, typically due on the first day of the subsequent month, covers the interest for the entire preceding month without overlap. This establishes a clear payment schedule from the outset.
Other Common Prepaid Expenses
Beyond property taxes, homeowners insurance, and mortgage interest, other prepaid expenses may arise during the closing process. An initial escrow deposit is commonly required by lenders to establish a reserve for future tax and insurance payments. This deposit acts as a cushion in the escrow account, typically amounting to two to three months’ worth of combined tax and insurance payments, to ensure sufficient funds are available when bills come due. This amount is separate from the ongoing monthly contributions to the escrow account that are often part of the mortgage payment.
For properties located within a homeowners association (HOA), buyers may be required to prepay a certain number of months of HOA dues at closing. These prepaid HOA fees contribute to the community’s operating budget and reserve funds. The amount is often calculated as two to three months of the regular assessment. Additionally, if a buyer makes a down payment of less than 20% on a conventional loan, some lenders may require an upfront payment of Private Mortgage Insurance (PMI) premiums for a certain period.