Prepaid Costs When Buying a Home

Ever hear the expression, “Clear as Mud?” It simply means that the subject is not as easy to understand, and with prepaid costs that isn’t the case. Purchasing a house can feel like that. In a simple world, purchasing a property would just mean handing a bank a down payment, and then making a monthly mortgage payment to pay down the loan. Basically homeownership is like that, but there are also other upfront costs when buying a home. Those costs are called closing costs and prepaid costs.

A prepaid cost are amounts that are related directly to the mortgage. Closing costs are costs that are related to the origination of the home loan. Both types of costs are required to pay upfront when closing on the property.

A breakout of both types of costs are itemized on a loan estimate document. This is sent to you by your loan officer and also includes the down payment on the house, the estimated mortgage payment, and the loan terms.

A more detailed and precise document is sent towards the end of the loan process called a “closing disclosure.” The closing disclosure is given to the borrower three days before the closing date.

To discuss prepaid costs, or prepaid expenses, we should first discuss what an escrow account is. An escrow account is an account that is set-up by the mortgage lender to put money aside for the costs that are associated for the specific property that is being purchased. This is to safeguard the buyer and seller in the transaction in regards common prepaid costs such property taxes, mortgage interest and homeowners insurance.

Prepaid expenses that are shown in the loan estimate and closing disclosure are taken care of in the initial escrow deposit. This is really just a buffer for the buyer. After closing, the mortgage lender or servicer of the loan will take a portion out of the monthly mortgage payment to save for mortgage expenses. Consider prepaid costs as upfront cash payments that will be used throughout the year.

If the borrower of the new property decides to escrow taxes and insurance, the borrower will see a initial escrow payment that is due at the time of closing.

When purchasing a home, mortgage lenders require that the buyer shops for a homeowner’s insurance policy. Homeowner’s insurance not only protects your assets, but it also protects the lender’s investment in the property in the event that a fire, flood, etc. damages the home. In the closing disclosure, homeowners insurance is in a section that tells the buyer that this is something that they can shop for. This helps the buyer have more power over their interest payment by looking for a homeowners insurance premium that fits their budget and needs.

A lot of paperwork happens when purchasing a property. When I bought my first home, my coworkers joked that it was like “signing your life away.” Because of the amount of paperwork, servicing requirements and other work that goes into the mortgage process, it typically takes a mortgage company 30 days to enter all of the information into the system.

Because of this, lenders require prepaid mortgage interest. This prepaid cost allows the lender to use the prepaid interest to cover the first mortgage payment. Lenders will typically collect 6 month to a year of prepaid mortgage interest.

Prepaid property taxes are taxes that are associated with the specific property. The city or governing council of that specific area requires homeowners to pay the tax based upon the assessed value. In Texas, property owners will receive a annual property tax bill.

The statement will include the assessed value of the property and the real estate property taxes. At the time of closing, The lender will determine how much prepaid property taxes will be collected.

Prepaid costs in Summary

When you are in the process of buying, expect your mortgage payment to have prepaid costs associated with it. Expect prepaid closing costs when buying and costs associated with your initial escrow deposit. At the end of the day, this is still your physical money, only being held by the mortgage servicer as a prepaid expense to be paid automatically for you covering homeowners insurance premiums, mortgage insurance premium (for FHA loans) and annual property taxes.