Contents
Which Prepaid Costs Are Included In The Mortgage?
Where To Find Your Prepaid Costs On Your Loan
Prepaid Costs Vs. Closing Costs
Don’t Compare “Other Costs” When Shopping Lenders
When buying a new home, it may seem like the home’s selling price is never as straightforward as you might expect. On top of the price tag, there are always additional fees and costs reflected in the transaction. Most home buyers expect to cover the down payment and closing costs, but buyers are also responsible for paying their prepaid costs, or “prepaids.”
Though lenders do their best to break down each cost highlighted in the loan estimate and mortgage disclosure documents, prepaid costs can come as a surprise to buyers who might need to become more familiar with these documents. Buyers can also mistake prepaid costs for closing costs and escrow because they have similarities, but ultimately, they are three separate business items.
To save you from additional buyer stress, we’ll explain what prepaid costs are when buying a home and give you tips for what to expect in your final transaction.
What Are Prepaid Costs?
Prepaid costs, also known as “Prepaids or Prepaid Items,” when buying a home include an initial escrow deposit, homeowners insurance premium, real estate property taxes, and mortgage interest. These costs are different from your closing costs. Mortgage companies typically outline these in your mortgage Loan Estimate document.
As the name suggests, prepaids are upfront cash payments made before your down payment to obtain a mortgage. Prepaid costs are paid at closing and placed into an escrow account to cover mortgage expenses typically included in monthly homeownership-related fees. When it comes time to make these payments, the lender will withdraw from the escrow account to cover the expenses, meaning in your typical scenario, you won’t need to pay any additional monthly costs.
Which Prepaid Costs Are Included In The Mortgage?
As you prepare to review your loan estimate and mortgage disclosure documents, knowing what expenses to look for is essential. Typically, the most common prepaid costs included in the mortgage are:
- The Homeowner’s Insurance Premium
- Real estate Property Taxes
- Mortgage Interest
- The Initial Escrow Deposit.
Prepaid Insurance And Taxes
Prepaid insurance and property taxes are standard upfront costs included in a mortgage transaction. Typically, when closing on your mortgage, you’ll prepay a 12-month premium for your first year of homeowner’s insurance. You have the flexibility to choose your insurance provider, and we recommend exploring various options to secure competitive premiums, rates, and coverages for your situation. Starwest is happy to refer you to a competitive insurance broker or provider if you are unfamiliar with the homeowner’s insurance landscape.
In addition, your mortgage lender will also collect property taxes from you. The amount collected can vary, ranging from up to 6 to 12 months’ worth of property taxes due for the year or current tax cycle. It’s worth noting that in a mortgage purchase transaction, you typically receive a tax credit from the seller at the time of closing, as indicated in the Closing Disclosure and Settlement Statement. This credit offsets the property taxes collected for the period the seller occupied the property during the current tax year.
Prepaid Interest
Mortgage interest is yet another upfront expense included in your mortgage. This cost is collected in advance to ensure the lender can cover the interest due from your closing date until the commencement of the loan repayment amortization schedule on the 1st of the following month. Consequently, no matter which day of the month you close, the lender will have a minimum of 30 days to input your information into their system before issuing your first statement.
However, the amount of interest required can vary based on the day of the month you close. For instance, some homeowners may opt to close a purchase transaction towards the end of the month. This choice reduces the accrued prepaid interest in advance, resulting in a lower amount due before your first monthly mortgage payment.
Initial Escrow Payment At Closing
The initial escrow reserves deposit is the final prepaid cost you should expect to be included in your mortgage. The initial escrow payment is reserves money deposited with the lender, which will be used to pay future homeowner’s insurance and property taxes.
Similar to the prepaid insurance and tax expenses, this initial escrow deposit will act as an extra cushion or safeguard in your escrow account. The initial escrow deposit goes above and beyond initial prepaids, and it will also continue to be held in escrow even after the first payments begin as a security precaution against the possibility of an escrow account shortage, an insurance premium increase, or rising property taxes. Expect your lender to require you to allocate two months of additional homeowner’s insurance and property tax reserves to be held in your escrow account (for example, if your annual property tax bill is $12,000, you’d prepay $2,000 into an escrow account).
Prepaids Summary
Summing up the prepaid premiums and initial escrow deposits, the exact amount collected varies by lender but typically encompasses a total of 14 months’ worth of homeowner’s insurance and up to 8 to 14 months’ worth of total property taxes (depending on your state) prepaid at the closing. In both cases, these totals include a 2-month escrow reserve deposit. The seller typically credits any accrued property tax charges at closing beyond the property tax reserves. The two months’ worth of collected homeowner’s insurance and property tax reserves will be deposited into an escrow account to serve as a cushion for you to cover future bills.
Where To Find Your Prepaid Costs On Your Loan
When you first get your mortgage Loan Estimate document, locating a description of your prepaid costs might be challenging. Typically, prepaid costs are broken out on page two of your Loan Estimate, often labeled “other costs” after the outlined closing costs. Once you locate this section, you should be able to identify the prepaid costs described in your loan.
In this example, the buyer’s prepaid homeowner’s insurance premium is $1,249, and the property taxes are $2,296.
- Initial Prepaid Premiums = 12 months of homeowner’s insurance + 6 months of property taxes, located in Page 2 of the Loan Estimate, Section F.
The buyer’s Initial Escrow Deposits are $208 in homeowner’s insurance and $765 in property taxes.
- Initial Escrow Payment = 2 months of homeowner’s insurance reserves + 2 months of property taxes, in Page 2 of the Loan Estimate, Section G.
Waiving Your Escrow Account
Many lenders provide the option to forgo setting up an escrow account. This choice places the responsibility on the borrower to manage homeowner’s insurance premiums and property tax payments independently and ensure they are paid punctually. However, this decision comes with potential risks, as homeowner’s insurance, often called “hazard” insurance, may become delinquent or canceled, and property taxes might remain unpaid, leading to the property incurring IRS tax liens.
It’s worth noting that some lenders may require a slightly higher interest rate to mitigate these risks when borrowers opt out of escrow accounts. On the bright side, Starwest’s lender relationships often offer flexibility, allowing you to make the escrow account a personal choice without incurring any interest rate penalties should you decide to take charge of your homeowner’s insurance and property tax payments.
Choosing to waive your escrow still requires you to prepay your first year’s homeowner’s insurance premium and upfront property taxes at the closing. The significant difference in this scenario is that you won’t establish an escrow account, which means you won’t need to make an initial escrow account reserve deposit. As a result, your monthly mortgage payment excludes taxes and insurance, consisting only of principal and interest.
Lenders usually mandate escrow accounts for government-backed loans such as FHA, VA, or USDA mortgages. Therefore, if a government entity insures your new loan, the option to waive the escrow account may not be applicable. Please double-check with your mortgage broker or lender about your specific escrow scenario.
New Build Property Taxes
Here’s where property taxes are slightly different if you’re moving into a newly constructed home. When paying property taxes on new construction, you’ll still pay your first prepaid property taxes and escrow deposit at closing, but the amount will be either significantly lower the first year than they will be moving forward or conservatively higher than what the fully assessed taxes might end up being. That’s because until your county has had a chance to send out an assessor to value your home and log that value with the local government, your property tax rate is based on unimproved land, meaning the value of the land before a house was there. Later, your property will be revalued as improved land, meaning your land plus your house. Understandably, that will mean a higher property tax bill over the unimproved land assessment.
Lenders employ various approaches when working with new construction buyers, especially concerning property taxes. Here are a few different methods:
- Estimated Assumed Rate: Some lenders may have you pay the estimated assumed rate for your improved property, erring on the side of caution. This results in you prepaying more upfront and setting aside more funds than needed, potentially creating an escrow surplus. While this approach offers the advantage of potential escrow refunds down the road, a conservative property tax estimate may lead to inflated monthly property taxes within your mortgage payment.
- Current Millage Tax Rate or Unimproved Land: Alternatively, lenders might opt for you to pay the current millage tax rate or taxes based solely on the unimproved land value. In both cases, this can result in a bill for additional money owed when your home is assessed at full value. Such scenarios can lead to an escrow account shortage as back taxes become due in a lump sum, potentially causing significant payment increases and payment shock.
- Waiving Escrow Account: If your lender permits it, waiving your escrow account for new construction can relieve the hassle and stress associated with escrow shortages and fluctuating monthly payments. However, it’s important to note that any fully assessed tax bill will still be due to the local county government.
No matter which path you select or what the lender offers, Starwest is here to provide guidance and education on all available options, ensuring you can plan and avoid any surprises or financial budget setbacks.
Prepaid Costs Vs. Closing Costs
You may hear these seemingly similar terms used interchangeably when referencing everything you’ll need to pay at closing, but they are two different types of expenses. Here’s what you need to know. Closing costs are the one-time fees a homebuyer pays directly to their mortgage lender and third parties for administering and processing the loan. These can include application and origination fees or charges to run a credit check. These costs also include payments to third parties for services, such as appraisal fees and title company charges.
Prepaids and closing costs are similar in that, as a homebuyer, you must pay them both when you close on the purchase. However, knowing the difference between the two and where your money is going is useful. While regular closing costs are paid directly to the provider, prepaids get held in escrow by your lender and distributed by them as needed.
Common Prepaid Expenses
- Homeowner’s Insurance Premium
- Property Taxes to County
- Mortgage Prepaid Interest
- Initial Escrow Payment
Common Closing Costs
- Loan-Related Fees
- Appraisal and Inspection Fees
- Title-Related Fees
- Attorney Fees (State-specific)
Don’t Compare “Other Costs” When Shopping Lenders
As you shop for a mortgage, the prepaid items will differ on the Loan Estimates you get from competing lenders. In other words, the dollar amounts in sections F and G won’t match up. One lender’s estimate for homeowner’s insurance, prepaid interest, or property taxes could be much higher or lower than other estimates.
Don’t choose one lender over another just because their prepaid items are less expensive. How much you actually prepay for insurance and taxes will end up being the same no matter which lender you select.
Lenders won’t know the insurance or tax amounts right after you apply for a mortgage. Instead, they provide approximate figures based on the available information at that time. Once you’ve chosen an insurance company and have an accepted purchase contract address, the lender can verify the exact amounts and issue a revised Loan Estimate.
If you seek precise figures now, consider obtaining a quote from your insurance company. For tax information, consult your real estate agent, mortgage broker, or access the county treasurer’s website for property tax details.
Seller Concessions and Lender Credits
Your Loan Estimate and Closing Disclosure documents will provide a detailed breakdown of all your closing costs, listed line by line. Sometimes, the home seller may agree to cover certain buyer closing costs as part of the sale agreement, a practice often known as seller concessions. Additionally, the lender may occasionally offer you, as the buyer, lender credits to offset closing costs. In both cases, any excess from seller concessions or lender credits can also be applied toward prepaid costs. Astute homebuyers can strategically leverage these credits to their advantage, aligning them with their long-term mortgage plans.
How To Calculate Your Prepaids On A Mortgage
To better help you calculate your prepaid costs, we devised three scenarios to illustrate how borrowers can calculate their prepaid expenses.
- Figuring Out Homeowners Insurance – Let’s start with a homeowner’s insurance example. Say you want to try and estimate 6 – 12 months of your future homeowner’s insurance premium. Homeowner’s insurance premiums can vary depending on your location, age and condition of your home, credit score, and history of premiums. Your home insurance rates might increase if you live in an area prone to natural disasters or destructive storms.
On the other hand, your home insurance rates might decrease if you’ve recently renovated an older part of your home or installed a new roof. According to data from Quadrant Information Services, the average annual homeowner’s insurance premium in the U.S. for 2023 is $2,417.10 annually. However, some states’ average rates are higher or lower than the national average. Talking to an expert like an insurance agent when calculating your unique homeowner’s insurance premium is important.
Once you have an estimated or exact amount for your annual premium, remember that you will make annualized payments toward this expense with the escrow account you will already have set up.
- Prepaid Property Taxes At Closing – As another example, you should calculate real estate property taxes based on where you live. To calculate property tax, multiply the property’s assessed value by the local tax rate.
Let’s say you want to move to Phoenix, Arizona, and the county’s assessed value of your home is around $650,000. The average tax rate in Phoenix (Maricopa County) is about 1.25%. So, to calculate your real estate property tax, you will multiply $650,000 by 1.25% or 0.0125. After calculating these numbers, you could expect to pay about $8,125 annually in property taxes.
If you want to try this formula for another city or county, you can likely find that area’s average tax rate online or search for a specific property address on your county’s assessor’s website for an exact annual property tax amount.
- Mortgage Interest At Any Time Of The Month – For our final example, let’s look at how to quickly approximate mortgage interest without a computer, dependent on what time of the month a borrower closes. First, remember that prepaid interest is typically calculated using the first day of accrued interest on your mortgage balance.
Now, let’s say you want to purchase a $400,000 home loan with an annual interest rate of 7.5%. If you close this mortgage ten days before the end of the month, you would take your annual interest rate and divide it by 365 to calculate your daily rate.
For example, 7.5% divided by 365 is roughly 0.021%. Next, multiply your daily rate by your home loan amount for your daily interest amount. So, in this case, 0.021% or 0.00021 times $400,000, which is ~$84. Finally, multiply the daily interest by the number of days between closing and payment to find the prepaid interest charge. $84 times ten days equals ~$840.
Now, you can see how the day you close your mortgage can impact your mortgage interest calculation. These scenarios give you a better understanding of prepaid costs by helping you apply these expenses to daily life and your home-buying journey.
The Bottom Line
While prepaid costs may seem like hidden additions to your home’s selling price or closing costs, understanding prepaids is vital for prospective homebuyers. These upfront expenses play a significant role in your financial planning, so distinguishing them from closing costs and calculating them accurately is crucial for a smooth home-buying experience. You now possess a more transparent comprehension of these expenses and how to identify them in your mortgage loan documents. As you progress through your home-buying journey, prepaids need not be a source of stress, and you can embrace prepaid expenses with confidence.
You’re now equipped with the knowledge to anticipate and plan for prepaids through calculated preparations. We encourage you to contact us or apply online now for help in closing on the home of your dreams.
Prepaid Costs FAQs
What are the standard prepaid costs I should expect? Your prepaid costs typically include an initial escrow deposit, homeowner’s insurance premium, real estate property taxes, and prepaid mortgage interest. Your lender should outline and itemize these costs for you.
How are prepaid costs different from closing costs? Closing costs are associated with loan origination, title company fees, and third-party services related to closing a mortgage loan. Also, it’s sometimes possible to get a seller to cover some closing costs, in which any surplus can go towards helping the buyer with prepaid costs.
Are prepaids the same as escrow? No, but they’re related. You put money for prepaids into an escrow account, but the amount in escrow may be greater than the initial prepaid. That’s mainly as a reserve precaution.
Are prepaid costs the same for every mortgage company? All mortgage companies make estimates, but how much you pay should be the same. It’s better to compare interest rates, terms, closing costs, and fees when choosing a mortgage lender other than the prepaids estimate.