There are a lot of seemingly similar mortgage terms to keep straight when you’re getting ready to close on a home, including “closing costs” and “prepaids.” You may hear these terms used interchangeably when referencing what you’ll need to pay at closing, but they are actually two different expenses. Here’s what you need to know.
What are mortgage prepaids?
Prepaids are the upfront cash payments you make at closing for certain mortgage expenses before they’re actually due. These include:
At the typical closing, your mortgage lender collects six to 12 months of homeowners insurance premiums, which it will then pay to your insurer. Generally, lenders require borrowers to obtain a homeowners insurance policy in order to take out a mortgage.
Your mortgage lender also estimates how much property tax you’ll owe, and typically asks for two months’ worth of property taxes upfront at the closing to build a reserve for when those payments come due. This money will be part of your initial escrow deposit (more on that below). From your escrow account, your lender will then make the property tax payments on your behalf to your local government.
If you close on any day other than the first of the month — the day most mortgage payments are due — your mortgage lender will collect prepaid mortgage interest at the closing and place it in the escrow account to be applied to your first mortgage payment.
The amount of prepaid interest you pay is calculated from the date of closing through the end of the month. This amount is your per-day (“per diem”) interest cost on the loan multiplied by the number of days left in the month.
Keep in mind that because your prepaid interest is based on the number of days between closing and the last day of the month, you can lower the amount of money you’ll need to bring to closing by scheduling the closing date for month-end.
Initial escrow deposit
To help create a cushion in your escrow account, your lender might also require an initial escrow payment at closing. This usually consists of two months of homeowners insurance, over and above whatever premium you pay at closing. Your two months of property taxes are also part of this deposit. This cash reserve helps ensure there is enough money available to pay those bills when they are due.
Once your mortgage payments kick in, your lender will continue to hold your monthly homeowners insurance and property tax payments in escrow. Note that these are collected with your mortgage payment in addition to the loan principal and interest.
Closing costs vs. prepaids
Whereas prepaids are upfront costs for expenses like property taxes that you have to pay for anyway, closing costs are the fees you pay to your lender and other third parties for administering and processing the loan. The closing disclosure document for your loan details all of these costs by line item.
Examples of closing costs include:
- Attorney fees
- Appraisal fees
- Title company fees and title insurance
- Government fees and taxes to record the property sale
- Real estate commissions (typicaly paid by the seller)
Although the home seller will sometimes cover closing costs as part of the sale agreement, the buyer always pays the prepaid costs when buying a home.
How to calculate prepaids
Recall that your prepaid expenses consist of:
- Six to 12 months of homeowners insurance premiums, plus two months for escrow reserves
- Two months of property taxes as set by your local government (for example, if your annual property tax bill is $12,000, you’d prepay $2,000 into an escrow account)
- Any interest that accrues on the loan from the closing date through the end of the month.
Your prepaids are calculated on Page 2, Section F of the loan estimate document you received from your lender, alongside closing cost details.
Comparing costs for a mortgage
Closing costs and prepaid items can add up to a sizable chunk of upfront cash, but you may be able to substantially lower that sum by doing some comparison shopping for mortgage offers and for some of the individual costs, such as the appraisal fee. Keep in mind that some costs are negotiable, and some are not.
Here’s a breakdown:
The loan estimate document contains sections for “Services You Can Shop For” and “Services You Cannot Shop For.” You can compare the services of third parties, such as title companies and surveyors, to find the best prices on any of the services you can shop for, and your lender is required to provide a list of companies that offer these services. Services you cannot shop for are chosen and required by the lender, so you’ll want to compare the overall cost of these items to other lenders’ loan estimates.
Property taxes are non-negotiable, but you can shop different lenders to see who offers the best mortgage rates in an effort to lower your overall loan costs. The same goes for homeowners insurance companies, as you may find a lower-cost premium or a bundle deal that saves you money. In addition, if you’re making a down payment of 20 percent or more for a conventional loan, you may be able to ask your lender to waive the escrow requirement. (If you waive this, however, you’re responsible for paying your own property taxes and insurance.)