You saved up enough money for your down payment and you think you’re ready to buy a home. Before you go too fast, determine if you have enough money to cover the closing costs? What about the prepaid costs – can you cover them too? Many buyers don’t realize these ‘other costs’ exist. While you can figure out the meaning of closing costs (lender fees, appraisal fees, etc.), what are prepaid costs?
Prepaid Mortgage Costs
As the name suggests, prepaid mortgage costs prepay your expenses. They cover your real estate taxes and homeowner’s insurance. You prepay the costs to set up your escrow account or the account the lender holds for you to pay your real estate taxes and homeowner’s insurance when they become due.
You’ll also prepay your interest, but only the amount that covers the closing date through the end of the month. Mortgage payments cover interest in arrears. In other words, the interest you pay in July covers the interest for June. When you close on a mortgage, though, you don’t make a payment for the first 30 – 45 days depending on your closing date. If you closed in June, for example, you make your first mortgage payment on August 1. The August 1 payment covers the interest for July, but you have to cover June’s interest at the closing.
The prepaid interest is usually only a small amount. Let’s say your per diem interest is $25 and you closed on June 16. You would owe 14 days of interest or $350 in prepaid interest.
You can minimize the amount you owe for prepaid interest by asking for a closing date as close to the end of the month as possible. The fewer days between when you close on the loan and the end of the month, the less interest you have to pay for the loan.
Figuring Out the Amount of Prepaid Taxes and Insurance
The amount you owe in prepaid taxes and insurance may be much higher. First, you’ll likely pay 12 months of homeowner’s insurance upfront. Lenders require a paid receipt good for one full year at the closing. Typically, lenders then collect two months of homeowner’s insurance at the closing for your prepaid insurance. Let’s say your homeowner’s insurance is $900 a year. You would pay $150 at the closing to cover two months.
The amount you owe in real estate taxes differs based on where you live and the due date for the taxes. Let’s use the same June closing date and say that your real estate taxes are due December and March. Since you would make five mortgage payments between the closing date and the due date for the taxes, the lender will require you to prepay some of the taxes to cover the missing month plus a cushion. Typically, lenders prefer a two-month cushion to allow for increases in taxes or other unforeseen issues.
The Difference in Prepaid and Closing Costs
Your prepaid costs are not your closing costs. Your closing costs cover the costs the lenders and other related third parties incur while processing your loan. A few common examples include:
- Underwriting fee
- Closing fee
- Processing fee
- Title search fee
- Title insurance fee
- Appraisal fee
- Attorney fees
- Document preparation fees
- Credit report fees
Each lender charges different fees. You can shop around so that you can compare each lender’s offer. We recommend that you compare the interest rate, closing costs, and APR before choosing a lender. Don’t focus on only the closing costs or the interest rate, but rather the big picture so that you know what to expect.
The prepaid costs will likely remain the same no matter which lender you choose. You have to pay interest on the mortgage, real estate taxes, and homeowner’s insurance. What may vary is the amount of the cushion that lenders require, which can increase or decrease the actual amount of money you must bring to the closing.