What are prepaid costs when buying a home?

When it comes to buying a new home, additional fees and costs always come with the transaction. Most home buyers expect to cover the down payment and closing costs but may not anticipate prepaid costs (or “prepaids”).

Lenders break down each cost in two key documents: the Loan Estimate and the Closing Disclosure. Borrowers receive a Loan Estimate from lenders 3 days after submitting a mortgage application and a Closing Disclosure from lenders at least 3 days before closing.

Buyers sometimes mistake prepaid costs for closing costs and escrow because they’re all paid at closing. To help you decipher which is which and guide you through each prepaid cost, we’ll explain what prepaid costs are when buying a home and offer tips on calculating prepaid costs before applying for a mortgage to help minimize surprises on closing day.

What are prepaid costs?

While you pay prepaid costs at closing, they differ from closing costs.

Prepaid costs go toward future housing expenses, such as property taxes. Your lender typically collects a portion of your monthly mortgage payment and deposits it into an escrow account. When payments are due (usually once a year), your lender will withdraw funds from the escrow account to pay them.

 Prepaid costs can include:

• Homeowners insurance premium
• Real estate property taxes
• Mortgage interest
• Initial escrow deposit

Prepaid costs when buying a home

Let’s take a look at the different prepaid costs you may see on your mortgage loan documents.

Prepaid insurance and taxes

Homeowners insurance and taxes are two common prepaid costs in a mortgage loan. Your homeowners insurance is typically prorated and prepaid at closing, covering you from when you purchased the home to the end of the year. In addition to prepaid homeowners insurance, you’ll likely pay prorated property taxes to cover the remaining property taxes from the seller’s last payment to the end of the year.

It’s up to the lender to determine how much to collect, but the prepaid amount will be deposited into an escrow account and act as an extra cushion for future bills.

Prepaid mortgage interest

Mortgage interest is another prepaid cost that goes toward your first mortgage payment. No matter which day of the month you close, you’ll receive your first mortgage statement 30 days after your closing date.

The amount you pay in interest will vary depending on the day of the month that you close. For example, some home buyers prefer to close at the end of a month to reduce the interest they pay upfront before their first mortgage payment is due.

Initial escrow payment at closing

The initial escrow deposit is the final prepaid cost you can expect to pay. It goes toward future homeowners insurance and property taxes. Look at your lender’s requirements to determine whether you need to make an initial escrow payment and how much it would cost.

Similar to prepaid insurance and taxes, the initial escrow deposit acts as a cash reserve in your escrow account, going above and beyond initial prepaids. It remains available in your escrow account even after your first mortgage payment.

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

Prepaid costs vs. closing costs

As we mentioned earlier, prepaid costs differ from closing costs. Prepaid costs are upfront costs that cover additional monthly mortgage expenses, like taxes and insurance. Closing costs pay the administrative fees for processing your loan, from the origination fee to the title search, appraisals and other costs associated with closing a mortgage loan.

Home buyers pay closing costs to the lender as a fee for all the services needed to process their loan. A Loan Estimate lists initial closing costs, and a Closing Disclosure outlines the final details of your mortgage loan, including every closing cost you must pay.

Another difference between prepaid and closing costs is that while the seller may cover some closing costs, the buyer always pays the prepaids.

Where to find your prepaid costs on your loan

After applying for a mortgage, you can usually find prepaid costs on page two of your Loan Estimate, often labeled as “other costs” after the closing costs section.

How to calculate your prepaids on a mortgage

Some home buyers want to calculate prepaid costs before submitting a mortgage application to estimate the total cost of homeownership. Let’s explore how to calculate each prepaid cost you may encounter.

Homeowners insurance estimate

Let’s start with homeowners insurance. You should estimate 6 – 12 months of your future homeowners insurance premium fees. Homeowners insurance premiums can vary depending on location, your age and credit score and the home’s condition.

Your insurance rates may be higher if you live in an area prone to natural disasters. On the other hand, your home insurance rates may be lower if you’ve recently renovated an older part of your home or installed a new roof. The average annual U.S. homeowners insurance premium is $1,544.

However, the average in some states can be higher or lower than the national average. Talk to an expert, like an insurance agent, when calculating your homeowners insurance premium. Call an insurance agency and get a quote for the home you plan to buy.

Remember that a portion of your monthly mortgage payments will go into your escrow account to cover your annual homeowners insurance premium. The lender will use the accrued funds to pay the bill at the end of the year.

Prepaid property taxes at closing

You must base your real estate property taxes on where you live. To calculate property tax, multiply the property’s assessed value by the local tax rate.

Let’s say you’re buying a $250,000 house in Chicago. The average tax rate in Chicago (Cook County) is about 2.1%. Multiply $250,000 by 2.1%, or 0.021. You’ll pay about $5,250 in property taxes each year.

Mortgage interest at any time of the month

The day of the month you close on a house will affect how much you owe in prepaid mortgage interest because prepaid interest typically covers accrued interest on your mortgage balance from closing to your first mortgage payment.

Let’s say you need a $200,000 home loan with an annual interest rate of 3.5%. Divide your annual interest rate by 365 to calculate your daily rate. With our example, that would be 3.5% divided by 365, which is 0.0096%.

Next, multiply your daily rate by your home loan amount to get your daily interest amount. In this case, that would be 0.0096% multiplied by $200,000, which is $19.18.

Finally, multiply your daily interest by the number of days between closing and your first monthly mortgage payment to calculate your prepaid mortgage interest. If you close on the house 10 days before the end of the month, multiply $19.18 by 10 days, which equals $191.80 in prepaid mortgage interest.

Prepaid cost FAQs

Below are common questions and answers about prepaid costs and what borrowers can expect at closing.

What are common prepaid costs I should expect?

Your prepaid costs will generally include an initial escrow deposit, the homeowners insurance premium, real estate property taxes and mortgage interest. Your lender will outline the final costs in your Closing Disclosure.

How are prepaid costs different from closing costs?

Closing costs are fees related to loan origination, such as paying title companies and closing the mortgage loan. Sometimes, buyers can negotiate to have sellers cover some closing costs. Only buyers cover prepaid costs, and the funds go toward future housing expenses, such as property taxes and mortgage insurance.

Are prepaids the same as escrow?

No, but they’re related. The money for prepaid costs gets deposited into an escrow account. The amount in escrow can grow beyond the initial prepaid because your monthly mortgage payments contribute to it. The initial prepaid is an extra cushion to ensure there is always enough money in your escrow account to cover your pending bills.

Are prepaid costs the same for every mortgage company?

While all mortgage companies make estimates, how much you pay will be nearly the same. It’s better to compare interest rates, terms and fees when choosing a mortgage lender than to compare prepaid estimates.

The bottom line

Don’t let prepaid costs sneak up on you at closing. You can calculate or find them beforehand in your Loan Estimate or Closing Disclosure. Now, you know more than just what prepaids are. You know how to estimate and identify them on your mortgage disclosure documents.

Knowing what to expect can help you calculate your potential costs and find a home that doesn’t strain your budget. We encourage you to close on the home of your dreams and start on your mortgage application today.