Understanding Prepaid Expenses When Purchasing a Home

There are numerous real estate terms to familiarize yourself with when preparing to buy a house, including terms like “closing costs” and “prepaids.” These terms may seem interchangeable when referring to the payments required at closing, but they actually represent two distinct types of expenses. Here’s a breakdown of what you need to know.

Prepaid Expenses: A Key Aspect of Homebuying

Mortgage prepaids, also known as prepaids, refer to upfront payments made by homebuyers to cover specific expenses before they become due. Common prepaid costs typically include monthly expenses associated with homeownership, such as homeowners insurance premiums and property taxes.

Though they are often lumped together under the term “closing costs,” prepaids differ in a fundamental way. Instead of directly paying the vendor or provider, your lender will hold the prepaid funds in an escrow account and distribute payments as necessary. Notable examples of prepaids include the following:

Mortgage Interest

If your closing date falls on a day other than the first of the month, which is when most mortgage payments are due, your mortgage lender will collect prepaid mortgage interest during the closing process. This amount will be placed in an escrow account and applied to your first mortgage payment.

The prepaid interest you pay is calculated based on the period from the closing date until the end of the month. It represents your per-day interest cost on the loan multiplied by the number of days remaining in the month. Remember, you can reduce the amount you need to bring to closing by scheduling the closing near the end of the month.

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Homeowners Insurance

Lenders generally expect borrowers to acquire homeowners insurance to secure a mortgage. During the closing, mortgage lenders gather six to twelve months’ worth of homeowners insurance premiums, which they distribute to the insurer in monthly installments.

Property Taxes

Mortgage lenders also estimate the amount of property taxes you’ll owe and request a two-month upfront payment during the closing. This reserve is established to cover future property tax payments. From your escrow account, the lender will manage and remit the property tax payments on your behalf.

Initial Escrow Deposit

To create a buffer in your escrow account, your lender might require an initial escrow payment when closing on the property. This payment typically includes two months’ worth of homeowners insurance premiums in addition to any premium paid during the closing. It also encompasses the two months of property taxes mentioned earlier. This reserve ensures that sufficient funds are available to pay these bills when they become due.

After your mortgage payments commence, your lender will continue to retain your monthly home insurance and property tax payments in the escrow account. These payments will be collected alongside the loan principal and interest.

Calculating Prepaid Expenses

You can find details about your prepaid expenses on the closing disclosure that your lender will provide you with three business days before the closing. On the second page, under Section F, you will find the breakdown of these expenses alongside the closing cost details. The prepaid expenses typically encompass:

  • Six to twelve months of homeowners insurance premiums, plus a two-month reserve for escrow.
  • Two months of property taxes, as determined by your local government (for instance, if your annual property tax bill amounts to $12,000, you would prepay $2,000 into an escrow account).
  • Any interest accumulated on the loan from the closing date through the end of the month.
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Closing Costs: A Comprehensive Overview

Closing costs encompass the one-time fees that homebuyers pay directly to their mortgage lender for loan administration and processing. These costs may include application and origination fees, as well as charges for running a credit check. Moreover, they may also include payments made to third parties, such as fees for a real estate attorney, a title search company, or a home inspector.

Your closing disclosure document will outline all the closing costs as itemized expenses. While it is possible for the home seller to cover certain buyer closing costs as part of the sale agreement, known as seller concessions, the buyer is responsible for the prepaid expenses.

Understanding the Difference

As a homebuyer, you will need to pay both closing costs and prepaids during the closing process. However, it is essential to distinguish between the two and understand where your money is allocated: Closing costs are paid directly to the respective service providers, whereas prepaids are held in escrow by your lender and disbursed when needed.

Remember: When it comes to purchasing a home, it is crucial to have a clear understanding of all the expenses involved to ensure a smooth and successful transaction. If you have any questions or need further assistance, reach out to 5 WS for expert guidance.

Home Buying

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