What Are Prepaid Costs When Buying a Home, And How Do You Calculate Them?

Which costs are prepaid when buying a home?

When buying a home, prepaid costs are payments made at closing that are used to cover future home-related expenses, including mortgage interest, homeowners insurance, property taxes, an initial escrow deposit, and possibly mortgage insurance.

They’re called prepaid costs because you are paying upfront for expenses that are not yet due, effectively prepaying for things that you would have to pay for later, anyway. The lender or loan servicer holds the money in an escrow account until it’s due.

These costs differ slightly from closing costs and will be laid out in your mortgage Loan Estimate and Closing Disclosure.

If you’re feeling confused, rest assured: You’re not alone. Let’s take a look at what prepaid costs are and demystify this lesser-known closing cost.

Prepaid costs you can expect to pay

Homeowners insurance premium

Your lender will need you to pay your homeowners insurance premium up front to be sure that the home is protected against covered losses on the day the house becomes yours. They’ll typically require that you pay one full year of insurance at closing. Once you close on the house, the escrow company (where your escrow account is established for the buying process) will pay your insurance company out of that escrow account.

From there, your homeowners insurance premium will be broken up into 12 installments and included in your monthly mortgage payment to be deposited into the escrow account with your servicer.

Specific hazard insurance

Depending on your area, your lender may require — and you may want — insurance to protect against specific hazards like floods or earthquakes.

In this case, the lender would also collect one year of the insurance premium, and it would be paid out of your escrow account in the same way as your other homeowners insurance.

Mortgage interest

Interest begins to accrue on your mortgage from closing day. But the day you close on the house isn’t the day you make your first mortgage payment. Prepaid mortgage interest is the interest you’ll accrue between closing day and the end of the month.

Because your mortgage payment is paid in “arrears,” and your first payment will not be due until the first day of the month after you have owned the house for 30 days, you are prepaying for mortgage interest for the days you will own the house but have not yet had to make a payment.

Let’s see how this looks with real numbers on a $350,000 mortgage loan amount with 15 days between closing and the end of the month.

Interest rate  /  Days in a year  =  Daily interest rate

5.0%  /  365  =  0.0136%

Mortgage amount  x  Daily interest rate  =  Daily interest accrued

$350,000  x  0.0136%  =  $47.60

Daily interest accrued   x  Days between closing and month’s end  =  Prepaid interest

$47.60  x  15  =  $714.00

With this in mind, you may want to schedule your closing toward the end of the month to lower the amount of interest you’re prepaying before you make your first actual payment on your mortgage.

Property taxes

To ensure that property taxes are paid in full and on time, your lender will require that any outstanding property tax installments be paid at closing. Your lender might also include these taxes in your mortgage payment, and then they will hold the funds in an escrow account until they are due.

Property taxes are based on the assessed value of your property, not the appraised value, and your lender will give you an idea of what your annual property tax bill might look like using your new assessed value and your local tax rate. You can also find your local mill rate and multiply it by the new assessed value of the house.

When you buy a house, the amount of property taxes you’ll owe at closing will be calculated based on the time of the year that you close and will be prepaid into the escrow account established by your lender or servicer.

Helali explains, “When it comes to a loan closing, if somebody is including property tax as part of their monthly payment, they’re going to be paying their prorated amount depending on the time of year of closing in comparison to the next property tax due date.

“This is because the bank wants to make sure that when you close, any prorated or prepaid amount that you’re paying upfront, along with your normal monthly payment, puts you in a position so that when taxes are going to be due, there’s enough money that’s been put aside to pay them in full.”

The amount you’ll pay for property taxes may also include money from the seller, depending on when the property taxes are due, or you may owe them money. Depending on your state, property taxes are either paid for the previous year or the upcoming year, and the due dates also differ depending on the state.

This results in two scenarios. For this example, we’ll assume that property taxes were due at the beginning of the year.

Mortgage insurance premium (if required)

If a lender requires you to take out mortgage insurance (MI), then the mortgage insurance premium could be included in your prepaid costs if it is being paid in a lump sum at closing. You might pay a lump sum at closing and a monthly fee, but mortgage insurance is more commonly paid monthly as a part of your mortgage payment.

>>Learn more: Estimate your private mortgage insurance costs before they surprise you at closing. Use the PMI calculator to see how much you could save and plan your budget smarter.

Initial escrow deposit

Surprise, there’s more! Even after you’ve covered your prepaid costs for mortgage interest, property taxes, homeowners insurance, and possibly mortgage insurance, there’s still one more prepaid cost you might be responsible for: Your initial escrow deposit.

An escrow deposit is essentially a “cushion” in your escrow account to cover increases in taxes and insurance rates. According to Helali, “Normally, in an escrow account, what needs to be collected is what’s needed to ensure that when taxes and insurance are due, they can be paid in full, but also a two-month cushion.”

He gives this example: “If somebody’s property taxes are $12,000 a year at the time that property taxes are due, in this person’s escrow, there’s going to be enough to pay that $12,000 plus two months’ extra. So in this case, there would be $14,000 sitting aside to cover that person’s taxes.”

This “cushion” amount will be calculated by the lender by taking the projected monthly cost of property taxes and the monthly cost of the first year’s homeowners insurance premium and multiplying by two.

It’s important to note that the money in the escrow account still belongs to the homeowner. It’s just being held until certain bills and premiums are due. If there is an excess in the account, the owner could be refunded, but in the event that there isn’t enough to cover expenses, the homeowner will have to pay the difference. This is usually solved with a slight increase in the portion of the mortgage payment for taxes and insurance to account for the extra cost.

The initial escrow deposit can also refer to all of the funds that are deposited in the escrow account created by your servicer, which could cover homeowners insurance, specific hazard insurance, property taxes, and possibly mortgage insurance.

Wait … what is an escrow account?

You may have heard the phrase “it’s in escrow” and seen the term “escrow account” when reading or talking about real estate, but it’s possible that you’re not one hundred percent sure what it means.

First, the phrase “in escrow” refers to the time between the offer and the close of the sale. After the purchase contract is signed by the buyer and seller and the buyer’s earnest money is deposited into the escrow account, the home is said to be in escrow.

An escrow account is basically a savings account that is monitored on your behalf. There are two different kinds of escrow accounts that you will encounter during your homeownership journey. The escrow account that is opened during the buying process will hold your earnest money deposit and the funds you wire for your down payment and closing costs until it’s time to pay everybody at closing.

After closing, your loan servicer will establish a new escrow account, sometimes referred to as an impound account. When you make your regular mortgage payments, the principal and interest are paid to the loan servicer, while the portion for property taxes and homeowners insurance is held in that new account until those payments are due.

When you pay your initial escrow deposit, that money goes into the escrow account to pay future expenses and create a cushion if costs increase or you fail to make a payment. That way, the lender doesn’t have to cover the extra cost (and increase your payment temporarily to pay it back) and can take out some of the cushion from the escrow account to pay your property tax bill or homeowners insurance premium on time.

Why does the lender collect prepaid costs?

When you borrow money from a lender, they’re giving you money on the condition that you pay it back (with interest). The lender wants to make sure that if something goes wrong, they are able to recoup their investment.

For example, if you have not paid your homeowners insurance premium and your house is destroyed in a natural disaster, the insurance company may not compensate you for the loss. If you still owe on your mortgage and stop making payments, the lender won’t have a home to foreclose on, and they wouldn’t be able to recover the money that you borrowed.

The same goes for your property taxes. Requiring that you prepay for your property taxes during the closing process ensures that you will avoid delinquency on those payments. Depending on your local tax authority, unpaid taxes could eventually result in an added property tax lien on the home and potentially losing the home to a tax auction or foreclosure.

Are prepaid costs and closing costs different?

While both are paid at closing, prepaid costs and closing costs relate to different expenses. Prepaid costs are for home-related expenses that you will need to pay regularly — mortgage interest, homeowners insurance, mortgage insurance, and property taxes. Closing costs, in contrast, are fees associated with the process of purchasing the home, such as mortgage origination fees, title fees, and so on.

Helali says that “prepaid costs aren’t a cost to acquire the property. They’re the costs of owning the property.”

How to estimate prepaid costs before you get a loan estimate

Estimating prepaid costs early can help you budget more accurately and avoid surprises at closing. While you won’t have exact numbers until your Loan Estimate, several strategies can give you a reasonable ballpark.

Where can I locate my prepaid amounts?

Your prepaid amounts will be listed on your Loan Estimate and Closing Disclosure, but they aren’t surrounded by flashing lights and neon signs. Your prepaid amounts will be listed in section F, and your initial escrow payment will be listed in section G of your Closing Disclosure page 2.

These may also be estimates, initially, as the final amounts depend on the homeowners insurance company that you choose, the current tax rate in your area, and whether or not you need mortgage insurance.

Can I save on prepaid closing costs?

Usually, prepaid costs are non-negotiable, but there are a few ways to try and reduce the costs you pay upfront. Property taxes are based on your local tax rate, so there’s no room for savings there.

Homeowners insurance, however, is based on the company you choose and the rates they offer. Depending on the company, and if you bundle your home policy with other policies, you may be able to find some savings there.

Closing at the end of the month might also reduce the amount of upfront mortgage interest that you will need to pay, which can also help save you some money at the closing table.

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Can I use a seller closing cost credit or a lender credit to cover prepaid closing costs?

In most cases, the answer is yes! Because your prepaid costs are included in the final closing cost calculation, seller credits can be used to cover prepaid costs. If you’ve opted to pay a higher interest rate in exchange for lender credits to offset your upfront costs, this money can be used to cover prepaid costs as well.

Making sense of prepaid costs

Buying a home and securing a mortgage can be a complicated process, and prepaid costs seem to fly under the radar. But it’s important to really understand everything you’re paying for when you buy a home. An experienced loan officer can help you make sense of the prepaid costs you may be responsible for when you close on your home.

Don’t let hidden costs catch you off guard when buying a home. Partner with an experienced agent who can break down every fee and prepaid expense. With the right guidance, you’ll know exactly what to expect and can budget with confidence.

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