Is there a difference between prepaids and closing costs?

When you look at your Closing Disclosure for your home purchase, you may notice a special category called “prepaids.” You may think, “Oh, those are just some additional closing costs.” If you closed on your home prior to October 2015 when new closing documentation was rolled out, you may have seen prepaids listed as “Items Required by Lender to be Paid in Advance” or “Reserves Deposited with Lender” on your settlement statement.

There is a difference between prepaids and closing costs.

Closing costs is the general term used to describe all of the fees or charges for actions or items related to originating and closing on your mortgage. These can include payment to title companies, government offices, or even the mortgage lender itself. People involved in your loan need to get paid and that happens through closing costs. Depending on the type of loan you get, you may be able to get the seller of the property to cover some or all of the closing costs during your sales contract negotiation.

What are prepaids?

As the term suggests, you are paying in advance for something. At some point in your life, you’ve probably been asked to pay in advance for a service. Most cable providers require payment in advance for the next month of usage. Your car insurance premiums are paid in advance. If you need an attorney, you may be asked to pay a retainer for their services. You get the picture – you prepaid for something you were going to be using later. Your mortgage lender asks you to prepay a few things as well.

Types of closing costs

What are you prepaying when you get your mortgage?

Mortgage interest, real estate taxes, homeowner’s insurance, hazard insurance, private mortgage insurance, and any special assessments (usually related to real estate taxes) are the most common items you’ll see listed as prepaids. In order to create an escrow account, your lender needs money to place in the account. At closing, you’ll be asked to pay a portion of your taxes and insurance, including private mortgage insurance if applicable, as prepaids for this purpose. Depending on when you close, you may not have a payment due for another 30-45 days which would delay your lender being able to fully set up your account in their system. Including a portion of these items in your closing allows them to have your account ready for future deposits and disbursements before your first payment is made. Going forward, all of these items are collected as part of your regular mortgage payment. “There is a regulated amount that can be put into this account at closing. The amount collected at closing along with the monthly payments will combine to be sufficient to pay the taxes and insurance when they come due. Escrows are required on FHA and VA loans. They may be waived on a conventional loan if the LTV is 80% or below,” explains Bob Dineen, Regional VP and Branch Manager, at Atlantic Bay.

“Prepaids are not a closing cost or a fee. They are the borrower’s own funds being put into an escrow account for the purpose of paying taxes and insurance.”

How is prepaid mortgage interest calculated?

Your mortgage payment consists of principal and interest. Principal is applied towards your loan amount and interest is paid to the lender for giving you the loan. Here’s where it gets a little tricky – interest is paid in arrears. When you make your mortgage payment, the interest is for the previous month. When you make June’s mortgage payment, you’re paying May’s interest. However, when you close, there may be a short period of time that needs to be covered and you’ll pay that as prepaid interest. For example, if you close on April 15 and your first payment is due on June 1, your June payment will cover all of May’s interest. But, what about the interest from April 15 – May 1? You’ll pay that at closing as a pre-paid. In order to reduce the amount of prepaid interest, you’ll probably be like most people and try to get a closing as near to the end of a month as possible. Your lender can help you estimate the amount you’ll need in prepaids so that you can make sure to have the funds available.

Can the seller pay for your prepaids with the rest of your closing costs?

Maybe. If your sales contract includes language that states that your seller is paying just closing costs, then you can’t include prepaids. It’s important that you have your contract state both closing costs and prepaids are being taken care of by the seller. Be careful, though, because some loan types put restrictions on how much your seller can cover. Ask your mortgage banker what is acceptable. If you have any questions at all about your closing disclosure or any of the costs associated with your loan, please contact us today.