What Are Prepaid Costs When Buying a Home?
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Summary:
Prepaid costs are some of the costs associated with purchasing a home in addition to the down payment and other closing costs. These costs need to be paid upfront at closing and are different from monthly recurring costs. These prepaid costs — for taxes, insurance, and mortgage interest — can come as a surprise for some first-time homebuyers, so be sure to factor them into your purchase.
When you’re ready to buy a home, you will probably look at the nearby schools, the backyard, the kitchen, and an area where you can grow your family of future cancer-saving doctors and Nobel Prize-winning physicists. After you have chosen the home you want to buy, you’ll have to add up all the costs. Your down payment and your mortgage value are easy to calculate in your head, depending on what type of loan-to-value ratio your lender offers. However, there are other lumps of cash you will need to facilitate a proper closing, including prepaid costs. We’ll help you understand how these costs figure into your overall home purchase.
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Prepaid costs 101
Prepaid costs are costs that you need to pay when you buy a home in addition to your monthly mortgage payments. These costs cover fees related to the mortgage and home ownership, such as HOA premiums, taxes, and mortgage interest. These costs will be sent to the title company or escrow agent involved in the transaction process to be placed in an escrow account.
Pro Tip
The reason for these prepaid costs lies primarily with the lender. The lender needs to make sure that all fees are paid in relation to home ownership along with the mortgage. Although they might sound similar to closing costs, they are different. In fact, prepaid costs are paid along with closing costs.
What do prepaid costs consist of?
Any lender can demand that you prepay for pretty much any expense if they require it to lend to you. However, prepaid costs, in most cases, come in four forms.
Prepaid taxes
The lender needs to make sure your property taxes are paid on time and thus will request that you put a certain amount into an escrow account upfront. The reason for this is pretty simple. When looking at the seniority of debt in a typical residential mortgage, the lender will have the first lien on the property. However, there is one entity that will always supersede the bank for seniority in debt, and that is the government. By making you pay your property taxes right away, the lender protects themselves from any issues with your property taxes.
HOA fees and insurance
Just as the lender wants to make sure you pay your property taxes, they want to ensure that you have the property’s HOA premiums and insurance covered. Each lender will have different parameters for which insurances and HOA fees you need to pay upfront and for what amounts. Prepaid homeowners insurance is usually required, so the homeowners’ insurance premium makes up part of the calculation you use to determine your mortgage payment.
Mortgage interest
Mortgage interest is another prepaid cost that most lenders request at closing. It’s important to note that this does not include the principal of the mortgage; only the interest. Many lenders will only make you pay the first month’s interest upfront, separate from your monthly mortgage payments that you most likely have already calculated.
Down payment
As you need to put your down payment in escrow before closing, this could also be considered a “prepaid” cost. The amount depends on your loan-to-value ratio. For instance, if you buy a property with a 70% LTV, it means that you put 30% down. If the property costs $100,000, you need $30,000 sitting in escrow as a prepaid cost.
Prepaid costs are different from closing costs
Prepaid costs are not closing costs! Closing costs are the costs associated with the services required to close on the property. Some of these closing costs might include the following:
- Money to the title company or escrow agent for their services
- Attorney fees (if you had to hire one)
- Administrative and servicing costs for the lender
How much will you pay for prepaid costs and closing costs?
A buyer will need to send prepaid costs and closing costs to an escrow account to close the deal. Ralph DiBugnara, president of Home Qualified and senior vice president at Cardinal Financial, says that depending on the state where you live, these costs (apart from your down payment) will run between 2% and 4% of the loan amount. You can break them down into lender fees, state and city fees, title insurance, and the items in an escrow account. DiBugnara explains:
An escrow account is established to hold a reserve of taxes and home insurance that will be needed to maintain the property. The homeowner's insurance premium for the first 12 months will be paid upfront. Also, reserves for taxes will need to be held so they can be paid either for the first three and six months or to be paid monthly in the mortgage. This, plus the earnest money deposit, which is the deposit that is given at the signing of the contract to secure the home, and prepaid interest in mortgage payments (depending on what day of the month the loan closes), are the items you should be concerned about prepaying.Click to Tweet
Prepayment goes to escrow
When you transfer prepaid costs associated with closing on a home, you don’t send it directly to the seller or lender; instead, you use escrow. Escrow is an independent third party that acts as an intermediary between the buyer, seller, and lender in a real estate transaction. It ensures that the rights and interests of all parties are protected when transferring money.
Many of these prepaid costs will then be transferred on an intermittent basis, such as monthly or quarterly, from your lender to the relevant entities that need to be paid. This process is called disbursement.
A simple method to calculate prepaid costs
If you want to buy a home and don’t want to enter all the costs into a complicated Excel model, you can use this workaround to calculate your prepaid costs with a bit of a buffer.
Calculate three months’ prepaid mortgage interest
Calculate the interest on your mortgage and just multiply it by three. Many lenders will want one month upfront, but do three so you have a buffer.
Calculate your HOA and insurance fees for one year
If you will have homeowners association fees, you can ask your real estate agent to estimate the HOA fee for a year. Most lenders will want to see at least six months of HOA fees upfront, but many opt for one year. The same goes for any insurance, such as flood insurance or homeowners insurance, that you are required to obtain.
Calculate property taxes for one year
Calculate the property taxes, assuming the current state/county rate and the sale price of your home. Remember, most of the time, the county assessments of your property value will lag behind the market price. This means you are also giving yourself a buffer, assuming that the value of the property is more than the county assessment.
Calculate down payment
This is pretty simple. How much LTV did you get, and what’s the down payment? If you have a 70% LTV on a $100,000 property, that means you need to put $30,000 into escrow as a prepaid cost. Here is the complete formula:
3 months mortgage interest + 1 year of
+ HOA fees
+ Homeowners insurance
+ Property taxes
+ Down payment
= Total prepaid costs
+ HOA fees
+ Homeowners insurance
+ Property taxes
+ Down payment
= Total prepaid costs
Example: Nells Frye’s prepaid costs
Nells Frye wants to buy a property in the suburbs of Atlanta. He knows the property tax in the area and just asked the broker about his HOA and insurance premiums. The exact terms are not available yet so he doesn’t know how much to calculate for possible prepaid costs. He is buying the property for $440,000. Let’s do the math for him.
| Cost | Rate | Total |
|---|---|---|
| Down payment | 30% of $440,000 | $132,000 |
| HOA fees | 1 year at $300/month | $3,600 |
| Insurance | 1 year at $120/month | $1,440 |
| Mortgage interest | 3 months at $300/month | $900 |
| Total prepaid costs | $137,940 |
Nells will need to pay close to $138,000 in prepaid costs, with about $6,000 separate from his down payment. Again, this does not include closing costs, which need to be paid in addition to the prepaid costs to close.
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FAQ
Are prepaid expenses part of closing costs?
No, prepaid expenses are upfront cash payments that will go into an escrow account to cover expenses like taxes and homeowners insurance. Closing costs cover lender fees, title insurance, and other expenses involved in the sale.
What are estimated prepaid items on a mortgage application?
Estimated prepaid items could include property tax, homeowners insurance, HOA fees, and mortgage interest. As the mortgage application process is more intense than the pre-approval, you should have a good idea of what these costs are.
What is prepaid interest at closing?
Prepaid interest is one of the prepaid costs that go along with your initial escrow deposit. It’s a portion of the interest payments on your mortgage paid upfront to your mortgage lender. Sometimes you will only have to prepay one month of interest.
What is the difference between prepaid and initial escrow payments at closing?
You pay your prepaid costs to the lender one time at closing, and then the lender puts a certain amount, or initial payment, into your escrow account.
Is earnest money a prepaid expense?
Earnest money is prepaid, but it is more like a credit than an expense. Earnest money is used to reserve a property and is typically subtracted from the down payment if the deal goes through. Depending on the terms of the earnest money and sale, it can be fully refundable or non-refundable.
Key takeaways
- Prepaid costs are the costs associated with closing on the purchase of a home in addition to the down payment and other closing costs.
- In most cases, prepaid costs consist of a combination of an initial escrow down payment along with mortgage interest prepayment, HOA prepayment, insurance prepayment, and property taxes.
- Prepaid costs are different than closing costs (lender fees, title insurance, etc.) and must be paid along with closing costs to facilitate closing.
- It’s easy to calculate your prepaid costs by adding up all of the estimated prepayments you will have to make.
- Your prepaid costs combined with closing costs will be about 2%-4% of the total cost of the home.
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