Closing costs vs. prepaids: What’s the difference?

There are a lot of real estate terms to keep straight when you’re getting ready to buy a house, including “closing costs” and “prepaids.” You may hear these seemingly similar terms used interchangeably when referencing everything you’ll need to pay at closing, but they are actually two different types of expenses. Here’s what you need to know.

Prepaid costs when buying a home

Mortgage prepaids, sometimes referred to simply as prepaids, are upfront payments a homebuyer makes to cover certain expenses in advance, before they’re actually due. Prepaids commonly include monthly homeownership expenses like homeowners insurance premiums and property taxes.

Because they’re payable at closing, they are sometimes rolled into the umbrella term “closing costs” — but there’s a fundamental difference. Rather than paying the vendor or provider directly, your lender will park prepaid funds in an escrow account, from which they will distribute payments as needed. Common prepaids include:

Mortgage interest

If you close on any day other than the first of the month — the day most mortgage payments are due — your mortgage lender will collect prepaid mortgage interest at the closing. It will be placed in an escrow account to be applied to your first mortgage payment.

The amount of prepaid interest you pay is calculated from the date of closing through the end of the month. This amount is your per-day (or “per diem”) interest cost on the loan multiplied by the number of days left in the month.

Keep in mind that because your prepaid interest is based on the number of days between your closing and the last day of the month, you can lower the amount of money you’ll need to bring to closing by scheduling the closing date near month’s end.

Homeowners insurance

Generally, lenders require borrowers to obtain a homeowners insurance policy in order to secure a mortgage. At the typical closing, a mortgage lender collects six to 12 months of homeowners insurance premiums, which it will distribute to your insurer each month.

Property taxes

Mortgage lenders also estimate how much property tax you’ll owe in advance. They typically ask for two months of property taxes upfront at the closing to build a reserve for when those payments come due. This money will be part of your initial escrow deposit (more on that below). From your escrow account, the lender will then make the property tax payments to your local government on your behalf.

Initial escrow deposit

To help create a cushion in your escrow account, your lender might also require an initial escrow payment at closing. This usually consists of two months of homeowners insurance, over and above whatever premium you pay at closing. Your two months of property taxes are also part of this deposit. This cash reserve helps ensure there is enough money available to pay those bills when they are due.

Once your mortgage payments kick in, your lender will continue to hold your monthly home insurance and property tax payments in escrow. Note that these are collected with your mortgage payment in addition to the loan principal and interest.

How to calculate prepaids

Your prepaid expenses are calculated on the closing disclosure that you’ll receive from your lender three business days before the closing takes place. Find them on Page 2, Section F of the document, alongside closing cost details. They will consist of:

• Six to 12 months of homeowners insurance premiums, plus two months for escrow reserves.
• Two months of property taxes as set by your local government (for example, if your annual property tax bill is $12,000, you’d prepay $2,000 into an escrow account).
• Any interest that accrues on the loan from the closing date through the end of the month.
  

Closing costs when buying a home

Closing costs are the one-time fees a homebuyer pays directly to their mortgage lender for administering and processing the loan. These can include things like application and origination fees or charges to run a credit check. These costs can also encompass payments to third parties, such as fees paid to a real estate attorney, a title-search company or a home inspector.

Your closing disclosure document will detail all your closing costs by line item. Although the home seller will sometimes cover certain buyer closing costs as part of the sale agreement — commonly referred to as seller concessions — the buyer always pays the prepaid costs.

Closing costs vs. prepaids

Prepaids and closing costs are similar in that, as a homebuyer, you will have to pay them both when you close on the purchase. However, it’s useful to know the difference between the two and where your money is going: While regular closing costs are paid directly to the provider, prepaids get held in escrow by your lender and distributed by them as needed.