You’ve heard of closing costs, but what about prepaid costs?
Prepaid costs are the homeowners insurance, mortgage interest, and property taxes that you pay at closing when you buy a home. The “prepaid” in prepaid costs doesn’t mean you’re paying them before closing. They’re paid at closing, in advance of newly owning the home.
Prepaid costs are broken down into two sections in the loan estimate you receive when you apply for a mortgage.
(If you don’t apply for a mortgage and pay for your home in cash, be sure to find out what your homeowners insurance and taxes will cost before you go to closing.)
So, assuming you are taking out a mortgage to buy a home, what will your prepaid costs be, and how do you find them in your loan estimate?
Understanding your loan estimate
Within three business days of applying for your mortgage, the lender should send you a loan estimate detailing the terms of your loan, such as your estimated interest rate, monthly payment, fees, and closing costs.
Section F and Section G of your loan estimate detail your prepaid costs, including your initial escrow payment at closing (more on that below).
Pssst … nervous about going to closing? You’re going to be fine! Check out our posts on common closing costs, preparing for closing, and how to close on a home during COVID-19, and remember to be excited about becoming a homeowner!
Prepaid costs (Section F)
Section F in your loan estimate will be labeled “Prepaid Costs.” It will include your:
- Homeowners insurance premium — Typically, you’ll need to pay the premium for the first full year of homeowner’s insurance as part of your closing costs.
- Real estate property taxes — Depending on the schedule for property tax payments in your state, your lender will determine how much you owe and will collect that money upfront to hold in an escrow account to pay out when the tax bill is due. Expect to prepay anywhere from three months to a full year of property tax upfront at closing.
- Mortgage interest (also known as per diem interest) — Your first monthly mortgage payment will be due one month following the end of the month in which you close on your loan. For example, if you close on your loan on July 20th, your first payment will be due Sept. 1st. Remember that the interest portion of your monthly mortgage payment that’s due on the first of each month is for the previous month (unlike rent, which pays for the upcoming month). In the example above, your first payment on Sept. 1st would cover the interest for the remaining days in July and all of August.
Initial escrow payment at closing (Section G)
Your lender will most likely give you an escrow account associated with your mortgage loan. Your escrow account will collect some money from your monthly mortgage payment to be used to pay your homeowners insurance and property tax bills on your behalf.
(Wait a minute, what is escrow? We explain!)
When you go to closing, you’ll pay these for the upcoming year upfront in what your loan estimate refers to as your “Initial Escrow Payment at Closing” (Section G). Keep in mind that this initial amount may differ from what you’ll pay each month going forward.
Quick note: If you pay off your mortgage (congrats! 🥳) you’ll still have to make payments for your property taxes and homeowners insurance. However, it will no longer be collected automatically by your lender, as you will no longer have a lender. In this case, you may want to find out what those costs will be and budget accordingly.
Prepaid costs vs. loan costs
Since you find out what your prepaid costs are in your loan estimate, it’s easy to confuse them with your loan costs.
Loan costs, however, are the fees that pay for the origination and closing of your mortgage loan.
Your loan costs and prepaid costs together make up your closing costs, which you pay at closing when you become the official owner (yay! 🎉).
Still navigating the homebuying process? Here are more topics that may interest you:
- Seeing some deals on the market and thinking, “Should I buy a foreclosure?” We have six things to keep in mind.
- Is your dream home slightly out of reach? Here’s what to consider about starter homes.