Closing costs vs. prepaids: What’s the difference?

When you’re gearing up to buy a house, it’s essential to grasp key real estate terms, especially when it comes to expenses like “closing costs” and “prepaids.” While these terms might be used interchangeably, they actually represent two distinct types of costs involved in the home buying process. In this article, we’ll break down the differences between closing costs and prepaids, and explain how they factor into your home purchase.

Prepaid Costs When Buying a Home:

Mortgage prepaids, also known as prepaids, are upfront payments made by the homebuyer to cover certain expenses in advance, before they’re actually due. These typically include monthly homeownership expenses like homeowners insurance premiums and property taxes. While they are payable at closing, there’s a crucial distinction – instead of paying the vendor directly, your lender will hold these funds in an escrow account and disburse them as needed. Here are the common prepaids:

1. Mortgage Interest:

   • If your closing date falls on a day other than the first of the month, your mortgage lender will collect prepaid mortgage interest. This amount is based on the number of days between your closing and the end of the month.

2. Homeowners Insurance:

   • Lenders often require borrowers to secure a homeowners insurance policy. At closing, they collect six to 12 months of insurance premiums, which will be distributed to your insurer monthly.

3. Property Taxes:

   • Lenders estimate your property tax in advance and may request two months’ worth at closing to establish a reserve. This money will be part of your initial escrow deposit.

4. Initial Escrow Deposit:

   • To provide a cushion in your escrow account, your lender may require an initial escrow payment at closing, consisting of two months of homeowners insurance and property taxes. This reserve ensures there’s enough to cover bills when they’re due.

Calculating Prepaids:

Your prepaid expenses will be outlined in the closing disclosure provided by your lender three business days before the closing date. They will include:

• Six to 12 months of homeowners insurance premiums, plus two months for escrow reserves.
• Two months of property taxes based on your local government’s assessment.
• Any accrued interest on the loan from the closing date to the end of the month.

Closing Costs When Buying a Home:

Closing costs are one-time fees paid by the homebuyer directly to the mortgage lender for administering and processing the loan. These can encompass application fees, origination fees, and expenses for services like credit checks, as well as payments to third parties like real estate attorneys, title-search companies, or home inspectors.

Closing Costs vs. Prepaids:

Both prepaids and closing costs are paid at the closing of the purchase, but it’s crucial to understand where your money is going. While closing costs are paid directly to the providers, prepaids are held in escrow by your lender and disbursed as needed.

Conclusion:

Understanding the distinction between closing costs and prepaids is essential for any prospective homebuyer. By familiarizing yourself with these terms and their respective functions, you’ll be better prepared to navigate the financial aspects of purchasing a home. Remember, thorough knowledge of these expenses will help ensure a smoother and more informed home buying experience.