Contents
Escrow Accounts: What You Need to Know
Prepaid Costs Vs. Closing Costs
Taxes and Insurance May Be Collected
Payoffs and Payments: Unraveling the Complexities
Where To Find Your Prepaid Costs On Your Loan
How to Pay For Mortgage Prepaids
How To Calculate Your Prepaids On A Mortgage
Refinancing your mortgage can be a complex process with many financial intricacies. While it may seem daunting, understanding these aspects is crucial to making informed decisions. In this article, we will explore the differences between closing costs, prepaids, and escrows for refinances. We’ll break down the elements involved and offer insights to help you plan for this often intricate financial landscape. Whether you’re a seasoned homeowner or a first-time refinancer, this information will prove valuable in navigating your refinancing journey.
Prepaids: What Are They?
Refinancing your mortgage can be an effective way to lower interest rates, reduce monthly payments, or access equity in your home. However, it involves more than simply signing a new loan agreement. Understanding the financial components, such as prepaids and escrow accounts, is essential to making educated decisions and avoiding unexpected costs.
Before delving into the complexities of refinancing, it’s essential to distinguish between closing costs and prepaids. Closing costs encompass the expenses directly related to the loan process, while prepaids are the payments you would incur, regardless of whether you refinance. It’s worth noting that the costs of prepaids can be high, potentially running into thousands of dollars. Let’s take a closer look at what prepaids involve.
Prepaids: A Deeper Dive
Prepaids are payments you make at the time of closing, and they consist of four key components:
- Per Diem Interest: Per diem interest is a fundamental component of prepaids you owe when refinancing. It’s the interest amount accumulated daily on your mortgage, and you’ll owe it when you refinance. This aspect is further influenced by your loan payoff date and is discussed in detail in the “Payoffs and Payments” section. It represents the daily interest on your mortgage and is usually divided into two distinct interest rates and mortgage interest calculations, both contingent upon your closing date.
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Accrued Interest Owed: Starting from the first day of the month’s payment cycle and extending until the closing date, per diem interest owed to your current lender is factored into your loan payoff because mortgages are paid in arrears. Additionally, your payoff amount generally incorporates an extra seven calendar day’s interest cushion, serving as a safeguard in the event of unforeseen closing delays that could leave your lender short of funds to cover your loan in full. You can delve further into the details of this interest cushion in the “Padding The Payoffs” section.
For example, (see Fig 1.1) suppose you finalize the signing of your closing documents on October 10th, and your loan is scheduled for funding on October 14th, following the standard three-day right of rescission for a primary residence. In this case, your loan payoff will include 14 days’ worth of interest for October, plus a 7-calendar day interest cushion, totaling 21 days of interest accrued for the month of October. It’s important to note that this covers the interest accrued in arrears for the days leading up to your closing date, even though your November payment has not yet been made. This interest obligation essentially settles your current lender’s share of the interest during the transition period before your next payment cycle. The 7-day payoff cushion beyond the projected funding date of October 14th will cause a short-term interest overlap with prepaid interest due, introduced in the next section. Please keep in mind that any overestimated interest cushion collected on the loan payoff will be refunded to you from your current lender after closing.
- Prepaid Interest: Prepaid interest is an upfront expense incurred when you make an advance payment of interest on a loan instead of paying it in arrears. This practice is an industry standard during the closing of a refinance. Prepaid interest accounts for the interest that accumulates from the day of closing until the first day of the upcoming month, covered by your initial mortgage payment and computed at the new lender’s interest rate.
To illustrate, (see Fig 1.2) if your closing date falls on June 14th, there is a 17-day interest gap before the commencement of the monthly payment cycle (You count the funding day of the 14th). During this period, the new lender will charge the borrower prepaid interest from the 14th of June to the end of the month, June 30th. The official loan repayment and interest accrual period begins on July 1st, and the first mortgage payment on the new loan, including regular principal and interest payments, is scheduled for August 1st.
- Interest Overlap: In the prepaid interest example below (Fig 1.3), the accrued interest owed to the current lender in the loan payoff would encompass June 1st through June 14th. The illustration (Fig 1.3) shows that the 7-day payoff interest cushion overlaps days 2-8, or June 15th through June 21st, of prepaid interest. The payoff cushion starts on the day after funding because payoff and prepaid interest are both collected from each lender on the day of funding. The payoff interest cushion is calculated at the current loan’s interest rate, whereas the prepaid interest due is based on the new loan’s interest rate calculation.
Please remember in this example that if the loan funds are on time on June 14th, you will receive a refund of the 7-day payoff interest cushion after closing. However, if the loan consummates later than expected, let’s say June 15th, the new lender would update the prepaid interest due from June 15th through June 30th. Because of the closing delay, your current lender would use one day of the payoff interest cushion; therefore, in this updated example scenario, you would receive a refund of 6 days’ payoff interest from your current lender after closing.
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- Property Taxes: Property taxes become a significant factor in your mortgage refinance when the process aligns with the timing of property tax deadlines in your county. To illustrate, in Maricopa County, Arizona, the first half of property taxes is due on October 1st, with the second half due on April 1st of the subsequent year. Conversely, in Utah County, Utah, property taxes are payable once a year, typically on November 30th, unless this date coincides with a weekend. The timing of your refinance becomes significant as it directly influences the calculation of your property taxes for the entire year and property tax prepaids due at closing. If you are refinancing a newly constructed home or your home was built within the past one to two years, please reference the “New Build Property Taxes” section for more information.
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Homeowner’s Insurance: Homeowner’s insurance costs can vary because of the diverse renewal dates for each individual and their policy coverages. You’ll find more specific information about homeowner’s insurance and its implications for your refinancing process in the following section, as well as “Taxes and Insurance May Be Collected.”
- Initial Escrow Deposit At Closing: The final component of prepaid costs to anticipate in your mortgage closing is the initial escrow reserves deposit. This deposit constitutes funds placed with your lender designated for covering future expenses related to 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 use your coming property tax and insurance premium due dates in tandem with your projected first payment date on the new mortgage to calculate the tax and insurance reserves allocations for closing.
For instance, (see Fig 1.4) if your first payment date on the new loan is slated for March 1st and you reside in Maricopa County, Arizona, where second half property taxes are due in full to your new lender by April 1st. Pending you currently have an escrow account, your current lender has collected the previous 5-months property tax allotments through your normal mortgage payment cycle and deposited those funds into your existing escrow account. The new lender can only collect one month’s property taxes through your new monthly mortgage payment. Consequently, the new lender collects approximately six months’ worth of property tax reserves at closing (five months of taxes plus one month as a reserve). This amount ensures timely payment to the county and maintains a one-month property tax reserve for future escrow payments.
In the same scenario, assuming you renewed your homeowner’s insurance on December 1st of the previous year, the new lender’s escrow account is behind by three monthly insurance payments (see Fig 1.5). Therefore, the new lender would typically request a deposit of three months’ insurance payments and a one-month insurance reserve cushion to establish the escrow account. (For example, if your annual property tax bill amounts to $4,000, you would prepay four months’ reserves of approximately $1,333.33 into your new escrow account at closing).
Taxes and Insurance May Be Collected:
At the time of closing, you may be required to make payments for taxes and insurance premiums, even if you have chosen to waive your escrow account. Depending on how you pay for your homeowner’s insurance and taxes, the payment schedules, and renewal dates, it might be necessary to prepay several months’ worth or the premiums. This prepayment is designed to ensure that your taxes and insurance are covered during the initial setup period of your loan.
Mortgage servicers typically seek to collect these premium payments when they coincide with the refinance process and the due dates are before the first payment date of your new loan. This approach ensures your coverage during the loan’s initial setup phase. Collecting or verifying payment of these initial tax and insurance payments directly at closing eliminates the need for additional payments to your county and insurance provider in the upcoming months.
Escrow Accounts: What You Need to Know
Escrow accounts, often seen as financial safeguards, play a crucial role in refinancing. Here are some scenarios related to escrow accounts:
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Currently Have an Escrow Account:
If you currently have an escrow account, you can expect a refund from your current mortgage provider once your new loan closes and funds. This refund usually arrives within 30 days of the mortgage servicer being paid off.
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Have Escrows and Getting Escrows:
If you already have an existing escrow account and are obtaining a new one as part of the refinance process, the impact on your cash flow remains neutral over 90 days. It’s essential to highlight that the reason your cash flow remains equal over this timeframe is that you’ll receive a full refund of your existing escrow account balance from the previous lender after closing.
However, when considering a shorter 30-day timeframe, a different perspective emerges due to establishing a new escrow account. In this scenario, it might appear as though you are incurring additional expenses at the time of closing, as the new escrow account necessitates the pre-funding of several months of expenses. The increased costs at closing occur because the new escrow account must bridge the gap caused by the skipped mortgage payments.
The reason behind the increased closing funds tied to the new escrow account is the necessity to cover both the balance held in your existing escrow account and the escrow expenses until your first payment on the refinanced loan. Since you’ll be postponing 4 to 8 weeks of mortgage payments during the refinancing process, as outlined in the Payoffs and Payments section, the new escrow account must allocate funds for the expenses that would typically be paid during the upcoming weeks when no payments are made. Typically, this translates to an extra 1 to 2 months’ worth of taxes and insurance. As a result, whether you decide to refinance or not, the overall financial impact remains consistent when considered within a 90-day context.
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Have Escrows But Now Waiving Escrows:
If you choose to waive escrows on your new loan while already having an existing escrow account, you will receive a refund for the current escrow account after your loan closes and funds. However, you may be required to cover insurance or tax costs at the time of closing if your policy renewals occur before the first payment date of the new loan.
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 refinance. 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
- Accrued Interest Owed (Current Lender Interest added to Loan Payoff)
- Prepaid Interest (New Lender Interest)
- Initial Escrow Deposit
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 or mortgage broker or access the county treasurer’s website for property tax details.
Payoffs and Payments: Unraveling the Complexities
Understanding your mortgage payoff and upcoming monthly payments is critical when refinancing and essential for accurate budgeting. We’ll cover the key elements in this section.
About Payoffs:
Your mortgage payoff can vary, and the exact amount remains unknown until approximately ten days before closing. The rough estimate in the proposal will change slightly once the final payoff amount is determined. Several factors contribute to these changes:
- Per Diem Interest: The per diem interest owed is added to your payoff because mortgages are paid in arrears. To illustrate, your mortgage payment due on November 1st covers the interest accrued during the previous month of October. So, if you close your loan on October 10th, the payoff amount will encompass ten days of interest from October, even though your November payment is still pending.
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Your Current Mortgage Payment: If your current month’s payment is not yet due at the time of closing, it will be factored into your payoff, which will increase the overall amount. In this situation, you may experience a two-month payment skip rather than the usual one-month skip.
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Skipping a Payment: During the refinancing process, you can temporarily avoid making your next month’s mortgage payment due to the arrears-based nature of mortgage payments. This effective skip or deferment occurs because the upcoming month’s payment includes the interest accrued or accumulated in the previous month.
In certain situations, you may even effectively skip two months’ worth of mortgage payments. For example, in the illustration below (Fig 1.6), the October mortgage payment is due on October 1st but only late October 15th. If your new loan is funded before you make your October 1st payment, the interest for September and October through the funding date, plus an interest cushion amount, are rolled into your loan payoff amount. As a result, you won’t need to make your usual October 1st or November 1st payments to your current lender, and your first payment on the new loan will be expected on December 1st.
- Padding The Payoff: Your payoff may include a brief period of extra per diem interest beyond the closing date, which will be refunded following funding. This additional interest cushion typically spans approximately 7-10 calendar days. The extra interest padding ensures that the refinance process remains unaffected by any unlikely delays. Rest assured, any surplus of interest added to your loan payoff will be reimbursed by your current lender after the closing.
Calculating The Payoff:
In summary, the loan payoff amount is calculated by combining the remaining principal balance, the per-diem interest owed, an interest cushion or padding, and any applicable payoff fees charged by the mortgage servicer. This comprehensive sum is usually requested from the mortgage servicer approximately two weeks before closing, ensuring you receive the most up-to-date and precise estimates.
Navigating the intricacies of refinancing can be challenging, but we’re here to help. If you have any questions or require clarification, please reach out. We are committed to ensuring your refinancing experience is as smooth and informed as possible.
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 get 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, some of Starwest’s lender relationships 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 account may require you to prepay your first year’s homeowner’s insurance premium and property taxes at closing or show proof of payment to your insurance provider and county if renewals occur before the first payment date of the new loan. The key distinction in this scenario is that you won’t establish a new escrow account, eliminating the need for an initial escrow account reserve deposit. As a result, your monthly mortgage payment will exclude taxes and insurance, comprising 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 refinancing a newly constructed home. When paying property taxes on new construction, you’ll still pay your initial property tax escrow deposit at closing, but the amount can be different than what you are paying with your current lender because the new lender may temporarily assess your taxes differently. That amount can 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:
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Estimated Assumed Rate: Some lenders may have you pay the estimated assumed rate for your improved property, erring on the side of caution. This method 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.
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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.
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Waiving Escrow Account: If your lender permits it, waiving your escrow account when refinancing 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.
How to Pay For Mortgage Prepaids
Four methods are available to cover prepaids at closing, each offering a different approach to managing your financial obligations during this process. These methods can effectively address both your prepaids and closing costs, providing flexibility in how you handle these expenses.
Pay Cash At Closing
In practice, you can’t bring physical cash, or what is often referred to as “mattress” cash, to the closing table. Instead, you’ll need to utilize one of the approved methods, such as providing certified funds or arranging a wire transfer. These secure and regulated payment options ensure the smooth and legitimate handling of your financial transactions during the closing process.
Roll Prepaids and Costs Into The Loan
When refinancing your home loan, you have the option to increase the loan amount (assuming there’s room in the loan-to-value ratio [LTV] and your interest rate pricing tier) and finance any prepaids or closing costs rather than paying them out of pocket at closing. Given today’s interest rates and typical loan amount size, the monthly payment changes by approximately $5 to $10 for every $1,000 that is rolled into the loan on a 30-year mortgage. This strategy can offer financial flexibility while considering your long-term mortgage commitment.
Lender Credits
Your Loan Estimate and Closing Disclosure documents should provide a detailed breakdown of all your prepaids and closing costs, offering a clear view of every expense involved. Your mortgage broker or lender may extend lender credits to you, as the borrower, as a means to offset the closing costs. Any surplus from these lender credits can be directed toward covering prepaid costs. Savvy homebuyers can strategically use these credits, aligning them with their long-term mortgage goals to make the most of their financial arrangements.
Combination Of All Three
You have the flexibility to utilize any combination of the three methods mentioned to cover your prepaids and closing costs. For instance, you can benefit from a lender credit to offset certain costs, include a portion of the closing expenses and prepaids in your loan amount, and use certified funds to cover the remaining balance. This versatility empowers you to tailor your approach to your financial situation and preference, ensuring your closing process aligns with your unique needs.
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 home condition, 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, depending 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
Refinancing a mortgage is a significant financial decision that requires a thorough understanding of the various components involved. Prepaids, escrow accounts, and loan payoffs all play a crucial role in this process, and being well-informed can help you navigate the complexities and make more informed choices. Whether you’re a homeowner looking to refinance or just curious about the intricacies of this financial endeavor, this article has provided insights into the key elements that can impact your financial situation during a refinancing process. If you have any questions or need further guidance, don’t hesitate to seek assistance from professionals who can help you make the most of your refinancing experience. Your financial well-being is our priority, and we’re here to assist you every step of the way.
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.
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Prepaid Costs FAQs
What are the standard prepaid costs I should expect with a refinance? Your prepaid expenses typically encompass an initial escrow deposit, homeowner’s insurance premium, real estate property taxes, per diem accrued interest owed on your loan payoff, and prepaid mortgage interest to your new lender. Your lender should provide a comprehensive breakdown and itemization of these costs, ensuring transparency and clarity throughout the refinancing process.
How are prepaid costs different from closing costs? Closing costs pertain to expenses linked to loan origination, title company fees, and third-party services necessary to complete a refinance transaction. Additionally, there are instances where your broker or lender may offer you a lender credit to cover closing costs, in which any surplus credit can go towards helping you with prepaid costs and providing additional financial flexibility during the closing process.
Are prepaids the same as escrow? No, although they are interconnected. While you fund prepaids by placing money into an escrow account, the total amount held in escrow might exceed the initial prepaid sum. This excess amount primarily serves as a reserve for precautionary purposes, ensuring coverage and accounting for potential fluctuations. Additionally, the new escrow account is designed to cover the gap caused by any skipped mortgage payments. It’s important to note that after closing, you’ll receive a refund for any remaining balance in your current lender’s escrow account, ensuring you don’t lose out on any funds you’ve already set aside.
Are prepaid costs the same for every mortgage company? All mortgage companies make estimates, but how much you pay in prepaid expenses should be the same and relatively uniform. When selecting a mortgage lender, it’s advisable to look beyond the prepaid cost estimate and consider factors such as interest rates, loan terms, closing costs, fees, and the lender’s overall suitability for your specific needs and preferences as a borrower. This holistic approach ensures that you make an informed decision that aligns with your financial goals.