Mortgage Closing Costs Vs. Prepaids

There are a lot of seemingly similar mortgage terms to keep straight when you’re getting ready to close on the home, including “closing costs” and “prepaids.” You may hear these terms used interchangeably when referencing what you’ll have to pay at closing, but they are actually two different expenses. Here’s what you need to know.

What are mortgage prepaids?

Prepaids would be the upfront cash payments you are making at closing for several mortgage expenses before they’re actually due. These include:

Homeowners insurance
Property taxes
Mortgage interest
Initial escrow deposit

These expenses are among the monthly costs of homeownership. Your lender will park these funds in an escrow account, that they uses to pay for those bills when they’re due.

Homeowners insurance

At the normal closing, your mortgage company collects six to 12 months of homeowners insurance premiums, which it will then pay to your insurer. Generally, lenders require borrowers to acquire a home insurance policy in order to remove a home loan.

Property taxes

Your mortgage company also estimates how much property tax you’ll owe, and typically asks for two months’ worth of property taxes upfront at the closing to construct a reserve when ever those payments come due. These funds is going to be part of your initial escrow deposit (more about that below). Out of your escrow account, your lender will then make the property tax payments on your behalf for your municipality.

Mortgage interest

If you close up on any day apart from the very first from the month — the day most mortgage payments are due — your mortgage company will collect prepaid mortgage interest in the closing and put it in the escrow account to become applied to the first loan payment.

The quantity of prepaid interest you pay is calculated from the date of closing through the end from the month. This amount is the per-day (“per diem”) interest cost on the loan multiplied through the number of days left in the month.

Keep in your 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 a preliminary 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 found in this deposit. This cash reserve ensures there is enough money open to pay those bills when they're due.

Once your mortgage payments start working, your lender continues to hold your monthly homeowners insurance and property tax payments in escrow. Note that these are collected together with your mortgage payment as well as the loan principal and interest.

What are closing costs?

Closing cost is the fees you pay to your lender and other organizations for administering and processing the borrowed funds. This is different from prepaids, which are the expenses you spend upfront to other parties.

The closing disclosure document for the loan details many of these costs by line item.

Examples of settlement costs include:

Attorney fees
Appraisal fees
Title company fees and title insurance
Government taxes and fees to record the property sale
Real estate commissions (typically 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.

Closing costs vs. prepaids

Prepaid expenses

Homeowners insurance
Property taxes
Mortgage interest
Escrow deposite

Closing costs

Attorney fees
Appraisal fees
Other origination fees
Title company fees and insurance
Government taxes
Recording fees

How to calculate prepaids

Recall that the prepaid expenses consist of:

Six to 12 months of house owners insurance premiums, plus two months for escrow reserves
Two months of property taxes as set from your local government (for instance, if your annual property goverment tax bill is $12,000, you’d prepay $2,000 into an escrow account)
Any interest that accrues around the loan in the closing date with the end from the month.

Your prepaids are calculated on-page 2, Section F from the loan estimate document you caused by your lender, alongside closing cost details.

Bottom line

Prepaids and shutting cost is similar in that you’ll need to pay them both upfront whenever you close in your loan. However, it’s useful to know the difference between the 2 and where your money is going. This knowledge can help you negotiate with the seller to see if they’ll cover a portion of the costs.