What are prepaid costs of buying a home?

When you buy a home, you know you need to cover the down payment and closing costs. You might not be aware of what's coming in the way of prepaid costs, which are sometimes known as "prepaids" or "mortgage prepaids."

We’ll walk you through what each of the prepaid costs are when buying a home and give tips on calculating prepaid costs. That way, you won't get hit with any surprises when you close on your home.

Understanding prepaid costs

Common prepaid costs

Common prepaid costs typically fall within a small handful of categories. Getting your head around each one can help demystify what you can expect to see on your closing disclosure.

Before we jump in: When you buy a home, lenders break down each cost in two key documents: the Loan Estimate and the Closing Disclosure. Usually, you'll 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 is paid in one of two ways: directly from you to the insurance company or 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 prepaid cost you'll want to factor in is mortgage interest. Prepaid interest, also known as per diem interest, covers the interest that's been accruing from closing until 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.

The initial escrow 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.

This 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.

Property taxes

When you buy a home, you'll often 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. Like prepaid mortgage interest, you will usually pay a prorated amount that covers the days between closing and the first mortgage payment. These funds typically are held in escrow until your taxes are due.

Prepaid costs vs. closing costs

Prepaid costs and closing costs are different. Both are paid at closing but closing costs are fees for services rendered. Prepaid costs, on the other hand, are made-in-advance payments for future obligations. The table below lists which costs fall into which category:

While the seller might cover some closing costs, on the buyer's end, you'll always need to cover the mortgage prepaids.

How to calculate prepaid costs

Calculating prepaid costs is relatively simple once you break it down into manageable steps. 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

Usually, lenders ask for 12 months of homeowners insurance to be paid upfront at closing. Here's the easy part: the cost is essentially 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 ask for quotes from multiple insurance companies. It's best to try to get quotes on the earlier side – 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, you can determine your daily interest rate and then multiply that by the number of days that you will owe interest for. First you will multiply your loan amount by your annual interest rate. Then, you will divide that number by 365 (the number of days in a year). Finally, you will multiply that by the number of days between closing and your first mortgage payment.

Written out as an equation it would look like this if you had a $250,000 mortgage at 6.5%:

$250,000 (loan amount) x 0.065 (interest rate)/365 (days in a year) = $44.52 (daily interest amount)

From here you would multiply by the number of days between the loan closing and the day the first mortgage payment is due. For this example, let’s say your mortgage closed on September 24 and your first mortgage payment is due on October 1. This means you would owe 7 days of interest (September 24 through September 30). This means you would owe:

$44.52 (daily interest amount) x 7 days of interest between closing and payment = $311.64

Initial escrow deposit

Typically, lenders will ask to collect two to three months' worth of insurance and tax payments up front. These funds will be used to "seed" your escrow account.

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: Your homeowners insurance costs $150 a month. Next, you multiply that by three and get $450. As for your property taxes, it's $300 a month. So multiplied that by three, you get $900. In total, $900 + $450 = $1,350 total. This is equal to 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.

Prepaid property taxes

To estimate the amount, 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. The lender requires six months prepaid. If that's the case, the estimated amount is $1,800.

Where to find your prepaid costs on your loan

Now, we'll walk you through exactly where you can find prepaid costs. These are located on two key loan documents:

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

The LE will be provided to you early in your home-buying process. The CD is given closer to the final steps of closing. The prepaids are listed in the CD on page 2, Section F.

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. You aren't alone. Professionals are at your side to help you make these things clear.

FAQ

Can I negotiate prepaid costs with the seller?

Prepaid costs are usually the buyer’s responsibility. They're less negotiable than other closing costs. But, in some cases, negotiating is possible.

Are prepaid costs refundable if the deal falls through?

In the case that the sale doesn't close, mortgage prepaid costs are usually refundable. That being said, refund conditions are dependent on the conditions in 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

Prepaid costs play a key role in the process of buying a home. When you know what they are and what you’re responsible for, it can mean a smoother closing experience.

You can plan ahead for these expenses and start your loan application with Rocket Mortgage® today.