Prepaid items on your mortgage sound like they should be straight forward. But you’re not alone if you’re a little puzzled when you review your closing disclosures or loan estimate. The documents look different and many people confuse prepaid items with their closing costs.
Let’s take a look at what exactly are prepaid items, how each one works, and how they differ from your closing costs on a home.
What are prepaid items?
Prepaid items are payments made in advance for specific expenses that are required to get your mortgage.
More often than not, you will need to establish an escrow account in order to pay for some of these in advance - such as your insurance and property taxes. This is commonly required by lenders. By having an escrow set up by your lender, your home is protected from liens for missed payments on taxes. When you close on your home, the escrow account will be used to pay part of your insurance and taxes as prepaids.
Prepaid items can include a number of expenses, such as hazard insurance, private mortgage insurance, and special assessments. However, we want to focus on three others. The three most common prepaid items are:
- This represents the prepaid interest due from the closing date until the end of the closing month. This is applied to your first mortgage payment.
- For example, if you closed on April 1st, your first full payment is due on May 1st. Or, if you closed on the 15th of a month with 30 days, you’re required to pay 15 days of interest at closing.
- In most cases, you will pay the first 12 months of homeowners insurance at the closing. Your lender will set up the payment through your escrow account. Most lenders include this in your cash to close.
- In addition, lenders require the escrow account to be started with a portion of the amount billed to be added to your payment, 1/12 of the total. Bill = $600/12 = $50 as the escrowed amount. The lender is allowed a cushion of two or three months to begin the escrow account. This money is set aside to cover missed payments or increases in insurance premiums.
- Property taxes are usually due twice annually, which can include city, county, and state taxes. Property tax escrows are calculated by using the number of months after closing before the next payment is due and adding two months to that for the cushion.
- For example, if the next bill is due three months after you close, your escrow would typically be five months worth of the annual tax bill.
Here are a couple of examples of how your prepaid items on your mortgage would look on your closing disclosures. The first is for a purchase and the second is for a refinance:
Is there a difference between prepaid items and closing costs?
Prepaid items are not considered closing costs. They are payments you would have had to make regardless.
Closing costs are the payments needed for services that are required for processing your home loan. The money brought to the closing table to pay for these services is often referred to as “cash-to-close.” The list of possible closing costs will vary depending on your mortgage lender. Some of the services you can shop for yourself, which includes attorney fees, pest inspections, and architectural/engineering fees. Other common fees that are required to be paid include title insurance fees and wire transfer fee. You can view a full list of possible closing cost services here. In addition, we have a blog that dives in-depth into both closing costs and down payments to give you a bigger picture of much money you’ll need on hand when you buy a home.
Get familiar with home finances first to set expectations.
There is a plethora of terminology and financial information to become acquainted with as you begin your mortgage approval process. The best thing you can do is familiarize yourself early. To start, use our free and anonymous mortgage calculator on our home page. You can search live rates and review fees (including estimated closing costs and prepaid items) in real-time.
In addition, you should orientate yourself with the basics of the mortgage process. Make sure to download our free guide for first-time home buyers. You’ll learn how everything works step-by-step and set expectations early in your home buying journey.