If you are like me, you want to know exactly how much you will be paying when you buy a house. I want to know the exact amount of my monthly payment so I can budget properly. But I also want to know what my closing costs are so I can make sure the money is in the right account. One number is hard to calculate. In this article, I’m answering the question: What are Prepaids in Real Estate.
The very last step of buying a house is signing all the paperwork on the closing date and handing over your down payment and closing costs at the title company. There are lots of different pages to sign, and usually a table or spreadsheet of costs and numbers. Most are easy to explain and understand. Prepaids can be an unexpected surprise.
What are Prepaid Costs?
Prepaids are one-time costs that are collected at closing, but not part of your closing costs. There are three common prepaids: Homeowner’s Insurance, Property Taxes, and Mortgage Insurance. Each prepaid has a different purpose, and I will review each below.
I like to think of prepaid costs as getting a head start on your escrow account or impound acount. You can find them on your final closing disclosure or settlement statement. Unfortunately, the final version of your closing disclosure doesn’t come until a few days before closing so it is difficult to know exactly what they are before the closing week.
What are common Prepaids?
It is important to understand all the different fees and costs when purchasing a home. Some cost are straightforward and easy to understand. Then there are the prepaids.
There are three common Prepaids. They are:
- Homeowners Insurance
- Real Estate Taxes
- Mortgage Insurance
Remember, closing Prepaids are only paid once, during closing. They are not a recurring cost that will appear in your monthly mortgage payment. But they can add up, so it is good to be prepared.
Generally, 3-12 months’ worth of homeowners Insurance is paid as upfront costs when you are buying a house. This money is an initial escrow payment. Over the year this account grows and then is paid to your carrier when the yearly bill is due.
In addition, in your monthly mortgage payment, you will also pay a part of it to go into your escrow account as homeowners insurance payments.
This means that YOU don’t directly pay your homeowner insurance carrier if you have an escrow account. Your lender will pay them with the money collected as prepaids and throughout the year when the bill is due.
As a result, your escrow account goes up and down throughout the year. You pay into it, and then your lender pays out at the needed time.
Additional information about Prepaids and Homeowners Insurance
Remember, you will be required to have homeowners insurance on your home if you have a mortgage loan. Cash buyers aren’t required, but it is a good idea to have it.
Also, your insurance premiums can vary based on your house, location, credit and many other factors.
It may be possible to negotiate with your mortgage lender and insurance company how much prepaids you are required to pay. Unfortunately, the amount is usually set and not adjustable. Talk to your insurance agent for all the details so you can have the lowest homeowners insurance premium you need.
Real Estate Taxes
Another prepaid that is collected at closing are property taxes, or real estate taxes.
Usually, 2-4 months of Real Estate or property tax payments are collected at closing. This sum is also put into your escrow account.
Again, every month, in your mortgage payment, a part of that money will be collected and added to the escrow account to make sure you have enough when the Tax bill is due. The mortgage company will then directly pay the taxes with the money from the escrow account.
Additional information about Prepaid Taxes
Basically, it is like a forced savings plan. You add a little bit every month, and then when the tax bill is due you have enough to cover the entire cost.
Prepaid property taxes are NOT collected if you don’t have an escrow account. This means you will have to pay the entire Tax bill when it is due on your own. Make sure you know when your property tax is due, and how much it is so you won’t be surprised when that time comes.
It is also possible to avoid having your taxes collected in your monthly payment if you have a mortgage. However this can be risky because often the taxes due are thousands of dollars every year, and if you don’t pay it, you could get a tax lien on your home, and even lose your house for not paying your taxes.
Private Mortgage Insurance, or MI, is collected by your lender when you don’t have 20% equity in your home. This is where the common 20% down number comes from when people talk about buying a house.
Of course, it is very common to have a lower down payment. If this is your situation, you will have Mortgage insurance until one of two things happen. Either you pay enough every month to get your principal amount to 20%, or your home can increase in value to achieve the 20%.
Will I know what my Prepaids are?
Part of knowing What are Prepaids in Real Estate is learning about your specific situation. At the beginning of the home buying process, you will get a pre-approval or pre-qualification letter from a lender. They may also give you a Good Faith Estimate, or GFE, or loan estimate documents, which shows your annual interest rate or APR and other closing costs.
The GFE may have a spot for Prepaids. Beware, this number is only an estimate. The Prepaids on your initial payment estimate page can (and usually will) be different from lender to lender. Not until the final CD is delivered approximately 3 days before closing will you know the exact number.
Your complete prepaids will be shown on your final closing disclosure. You will want to look in section f or section g to see all the different prepaid items.
To more accurately calculate the prepaids when you buy a house here are some suggested calculations. The best, and only way, to get the true number is to talk with your closing agent, or your lender.
How do You Calculate Prepaids?
Calculating your Insurance prepaid is fairly straightforward. Simply take your yearly homeowner insurance premium and divide it by 12. This is the monthly amount. Next, find out how many months of home insurance will be collected as prepaids and multiply the monthly amount times that number. This is your Insurance prepaid that will be collected at closing.
If your property insurance is $1,400 per year, we divide that by 12 months. $1,400 divided by 12 is $116.67. An additional $116.67 will be collected in your monthly mortgage payment, and between 3-12 months of insurance will be collected at closing. This could mean you will need an additional $350 -$1,400 as well at closing.
Finding your tax prepaid is more challenging. First, determine your daily property taxes. Let’s say that the house you are buying is $300,000 and your taxes are 2%. 2% of 300,000 is $6,000. You will pay $6,000 a year in taxes. Now divide that number by 12 months, and you get your monthly tax amount. In this case that is $500 ($6,000/12 months). You will pay an additional $500 on your mortgage payment for taxes.
Two to four months of property taxes will be collected at closing. This could be an additional $1,000-$2,000 at closing.
Both of these amounts, the prepaid insurance and prepaid taxes will be prorated to the day of the month you close.
Frequently Asked Questions about Prepaids
NO. Prepaids are a one-time fee collected at closing. They are to get a head start on your escrow account.
Mortgage monthly payments typically have four components. PITI is an acronym. It stands for
Principle, Interest, Taxes, and Insurance
The first two, Principle and Mortgage Interest, do NOT change with a fixed-rate home loan. For example, with a 30-year fixed, the Principle and Interest go unchanged for 30 years.
Taxes and Insurance are variable. They can go up and down over time. Because of this, it is possible for your monthly payment to change.
NO. Closing costs are different than prepaids.
Closing costs can include: Lender Fees, Title Fees, Transfer Fees, Lawyer costs, Title Insurance, and more.
To get your closing cost numbers you will need to talk with both your lender and your title or escrow company.
Some of these amounts are fixed, and some are negotiable. Fixed closing costs are the title or transfer fees. Adjustable closing costs can include the Lender and Lawyer costs. It is important to learn which are negotiable and which cannot be changed.
NO. Prepaids do not vary from lender to lender. One trick Lenders use to make their loans appear more attractive is to have a lower amount for prepaids on the Good Faith Estimate (GFE).
You don’t want any surprises on your first mortgage payment so be careful when selecting a lender. Prepaids are mostly set by the lender and escrow company. They may collect 3-12 months of insurance and 2-4 months of taxes, but this can vary based on your location and situation.
Now that you know What are Prepaids in Real Estate, you can be more prepared at the closing table. Nobody wants to pay more money, but these additional fees are usually mandatory. The variables that will determine your exact costs are the price of the home, the property taxes for your area, and your home insurance premium.
Remember, the day of the month you actually sign papers and close on your home will affect these amounts and different title companies may require different amounts. Prepaids are calculated for the remaining number of days in the month.
Determining your final prepaid cost isn’t difficult when you are prepared. The good news is you can figure out the number of upfront costs for your home purchase.
If you have any questions or thoughts, please leave them in the comments below.