What are prepaid costs of buying a home?

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One of the biggest hurdles to buying a home can be saving up enough money to cover your down payment and closing costs. As you get closer to closing day, you may be surprised to see that you may also owe prepaid costs on your mortgage.

Seeing another list of additional expenses can be overwhelming when you've already budgeted for so much. The good news is that prepaid costs aren't random fees or extra charges from your lender. They are simply advance payments for the ongoing expenses of homeownership that you would have to pay anyway – as opposed to lender or service fees. Lenders collect them in advance to make sure that property taxes and homeowners insurance bills get paid on time.

Here is a closer look at what prepaid costs are, how they differ from closing costs, and what you can expect to pay before you get the keys to your new home.

Understanding prepaid costs

While you pay both prepaid costs and closing costs at the time of closing, they are different.

Prepaid costs go toward anticipated housing expenses, such as property taxes or homeowners insurance. Your lender will collect a portion of your monthly mortgage payment and put it into an escrow account. When your property taxes and homeowners insurance bills are due, they’ll be paid out of that escrow account. The amount your lender collects will vary depending on your closing date, location, and lender requirements.

Common prepaid costs

Common prepaid costs include your escrow deposit, homeowners insurance, mortgage interest, and property taxes, When you buy a home, lenders break down each cost in two key documents - the Loan Estimate and the Closing Disclosure. You’ll typically get a Loan Estimate from lenders three days after submitting a mortgage application. And at least three days before closing, you'll also get a Closing Disclosure from lenders.

Homeowners insurance premium

When you take out a mortgage on a home, lenders usually ask that you pay anywhere from six months to a year's worth of homeowners insurance at closing. This makes sure the property is insured from day one and protects both you and the lender.

Homeowners insurance can be paid in one of two ways - either directly from you to the insurance company or from in an escrow account. If you choose to escrow this fee, then the payments are usually managed by your loan servicer.

Prepaid mortgage interest

Another common prepaid cost is for mortgage interest. Prepaid interest, also known as per diem interest, covers the interest that's been accruing on your mortgage between closing and the first mortgage payment.

Initial escrow deposit

The initial escrow deposit is an amount you pay at closing to start your escrow account, if it’s required by your lender.

This deposit is used to cover expenses like property taxes and upcoming homeowners insurance premiums. It is usually made toward the end of closing. If you want to know how much this amount will be, you can find it in section G on page 2 of your loan estimate.

The initial escrow deposit is different than earnest money, which is usually paid near the beginning of the transaction and shows that the buyer is committed to purchasing the property. The initial escrow deposit is also different than the down payment, which is the upfront sum a buyer pays toward the purchase of a home.

If your loan requires mortgage insurance, the lender may collect an upfront amount at closing or include it in escrow, depending on loan type.

Property taxes

Your local government levies real estate taxes on your home and land to fund community services and infrastructure. You'll commonly need to prepay part of your property taxes at closing. Property taxes are based on your property’s assessed value as determined by the local tax assessor.

The amount you pay typically depends on the market value and location of your property as well as your local tax calendar and closing timing. Like prepaid mortgage interest, you will usually pay a prorated amount that covers the days between closing and the first mortgage payment. Depending on your local billing schedule, you may owe more if you happen to be closing far from the next tax due date. The point is to ensure that there’s enough in your escrow account to cover the next tax bill. These funds typically are held in escrow until your taxes are due.

Prepaid costs vs. closing costs

Because you pay both prepaid costs and closing costs at the end of your home buying journey, it is easy to confuse the two. However, they serve very different purposes. Closing costs are fees from venders for services rendered, while prepaid costs are made-in-advance payments for future obligations. Closing costs pay for the transaction; prepaids pay for the first stretch of homeownership.

Closing costs are one-time administrative and service fees associated with processing and finalizing your real estate transaction. These include charges like your property appraisal fee, title search, and loan origination fees. Once your transaction is closed, you will not have to pay these specific fees again.

Prepaid costs, on the other hand, are strictly related to your future housing expenses. They are ongoing costs of homeownership that you are simply paying in advance.

How to calculate prepaid costs

Calculating prepaid costs can help you get a handle on exactly how much you’ll owe upfront for your mortgage. Remember, you can always discuss these costs with your lender and they should be able to help you get a sense of what you may owe.

Prepaid homeowners insurance

Lenders typically ask for up to one year of homeowners insurance to be paid upfront at closing. Here's the easy part – that cost equals the annual insurance premium.
For example: If insurance is $2,400 annually, the prepaid amount is also $2,400.

To snag the best price and coverage, you can shop around and ask for quotes from multiple insurance companies. It's best to try to get started on this early. That way, you'll have time to gather additional quotes if needed. It's a good idea to gather at least 3 quotes and to compare them side-by-side.

Prepaid mortgage interest

To calculate your prepaid interest, identify your daily interest rate and then multiply that by the number of days that you will owe interest. First, multiply your loan amount by your annual interest rate. Then, divide that number by 365 - the number of days in a year. Lastly, multiply that by the number of days between closing and your first mortgage payment.

For example, let’s say you have a $250,000 mortgage at 6.5% interest rate:

Loan amount x Interest rate / Days of year = Daily interest amount

$250,000 x 0.065 /365 = $44.52

$44.52 = Daily interest amount

Then, multiply by the number of days between the loan closing and the day the first mortgage payment is due. Let’s say your mortgage closed on Sept. 24 and your first mortgage payment is due on Oct. 1. This means you would owe 7 days of interest to cover Sept. 24 through Sept. 30.

Daily interest amount x Days of interest between closing and first mortgage payment

$44.52 x 7 = $311.64

Total prepaid interest = $311.64

Initial escrow deposit

Lenders typically will ask to collect two to three months' worth of insurance and tax payments up front. These funds will be used to make sure there’s enough money your escrow account when those bills come due.

To calculate the amount needed, divide your annual homeowners insurance and annual property taxes separately by 12 to get monthly costs. From there, multiply the number of months required. Last, add those together to figure out your estimated deposit.

For example, let’s say your homeowners insurance costs $150 a month. Next, you multiply that by three and get $450. Your property taxes cost $300 a month. If you  multiply that by three, you get $900. Then, $900 + $450 = $1,350 total. This is the cost of three months of homeowners insurance and property taxes.

If your down payment is less than 20% and your lender requires mortgage insurance, that will be deposited in your escrow account as a separate prepaid cost.

If PMI is required, you’ll typically be asked to pay one to two months up front, though this varies depending on the lender. For FHA loans, there may also be an upfront mortgage insurance premium. If so, it will be listed on your Loan Estimate.

Prepaid property taxes

To estimate the amount you’ll need to prepay for property taxes, divide your annual property tax bill by 12. Then, multiply it by the number of months the lender requires.

Let's say your annual taxes are $3,600 and your lender requires six months prepaid. The estimated total is $1,800.

Where to find your prepaid costs on your loan

Your prepaid costs will be located on two key loan documents:

• Loan estimate (LE)
• Closing disclosure (CD)

The LE will be provided to you within three days of applying for the loan. The CD will be provided to you at least three days before closing. The prepaids are listed in the CD on page 2, Section F. Numbers may change slightly from the Loan Estimate and Closing Disclosure so be sure to review both documents carefully. You can always ask your lender or real estate agent for help making sense of the numbers, or how to calculate how much you owe.

FAQ

Let’s go over the answers to some frequently asked questions about prepaid mortgage costs.

Can I negotiate prepaid costs with the seller?

Prepaid costs are usually the buyer’s responsibility. They're less negotiable than other closing costs. However, it’s possible to negotiate to have the seller cover portion of the costs in what are known as seller credits, which can range from 3% to 6% of the home’s sale price.

Are prepaid costs refundable if the deal falls through?

If the sale doesn't close, mortgage prepaid costs are usually refundable. However, refund conditions are dependent on the contract that you sign. You should carefully check the contract to be sure these costs are refundable in the case the deal falls through. You may also want to get expert advice on your contract.

Do all lenders require an escrow account for prepaids?

Not all lenders need you to have an escrow account. However, many do and they are a condition of certain types of loans. This especially rings true if the down payment is less than 20%. You'll want to talk about escrow requirements with your lender early in the process.

How can I reduce my prepaid costs?

To bring down your prepaid costs, you can shop around for the best rates for homeowners insurance. You can also close later in the month.

Are prepaids the same with every lender?

While the types of prepaid costs are usually the same, the amounts can vary by lender. That's due to different requirements or cutoff dates. To help you get a better understanding of what’s required, compare estimates from multiple lenders and ask plenty of questions.

The bottom line: Plan for prepaid costs

It is completely normal to feel a bit of sticker shock when you understand the full upfront cost of closing on your home. But keep in mind that your prepaid costs are not extra lender fees – they’re payments you’d have to make to keep your home protected and your taxes paid.

By knocking these payments out early, you get to spend your first few months of homeownership focusing on what really matters - settling into your new space and making it your own. Remember, you can always discuss these costs with your lender, and they should be able to help you get a sense of what you may owe.

Are you ready to take the next step on your home buying journey? You can start the mortgage approval process and explore your options with Rocket Mortgage today.