Buying a home has many documents and numbers, and you can quickly feel overwhelming. One term you might come across is “prepaid cost,” but what exactly does that mean?
Prepaid fees are fees that you pay upfront at the time of closing, and are covered before covering property taxes, insurance, etc. These fees have caught many buyers off guard, so understanding what they are and why they are necessary can help you avoid last minute confusion.
Whether you recently purchased a home in Portland or San Diego, California, this Redfin guide provides a quick guide to prepaid costs.
How much does it cost to buy a house?
When you close your home, liability for certain costs is transferred from the seller to you. To prevent missed payments, lenders ask the buyer to pay a portion of these costs in advance upon closing. These are not part of the traditional down payment or closing costs. They are similar to “pay now, cover later” fees.
These advance payments, known as prepaid expenses, cover property taxes and insurance before they are scheduled. Like your serious money deposit, these funds will be placed in your escrow account and held safely until you need to pay your bill.
So, what prepaid costs should you expect when you close?
Before you dive in, it’s important that your lender knows that you need to pay these costs upfront. Simply put, it’s about protecting everyone involved. These prepaid costs ensure that important invoices such as property taxes and insurance are covered from the start. That way no one will fall behind. You can confidently head to the closing.
This is a breakdown of the prepaid costs that lenders may need.
1. Fixed Asset Tax
Depending on when you close and live in, you may need to pay months of property taxes upfront. For example, let’s say it closes in October and pays taxes every year in November. You can prepay the remaining taxes for the year to avoid any remaining payments. Property tax schedules vary by location, so it’s important to know your local rules.
Tax bills don’t bother you when you buy a house, but they still need to be paid on time. Your lender just wants to make sure those bills are covered.
2. Homeowner Insurance
In most cases, you can pay the first year of your homeowner insurance the previous year when you close. It’s a must-have and your lender won’t approve your loan without it. Essentially, it makes sure your new home is protected from day one.
3. Mortgage interest
Here’s the tricky part: If you close in the middle of the month, interest will begin to accumulate from the day you take ownership, even though your first mortgage payment is not scheduled until next month. To cover that gap, your lender will collect prepaid mortgage interest at closing on the mid-day.
4. Escrow Account Fund
Most buyers have escrow accounts that cover future property taxes and insurance. Upon closing, you can place payments for several months of these payments in this account and lenders can pay the bills on your behalf.
5. Mortgage insurance
If your down payment is less than 20%, you will usually need to pay for your mortgage insurance. This protects lenders with loan defaults. In the case of traditional loans, it is called Private Mortgage Insurance (PMI). Usually, if you pay for the first month of PMI Premium at closing, it will be added to your monthly mortgage payments. PMI helps you get a loan with a lower down payment, but adds costs until you build enough stock to cancel.
What should I pay for prepaid fees?
Prepaid costs typically range from about 2% to 5% of the home’s purchase price. The exact amount depends on factors such as deadline date, local property tax rates, homeowner premiums, and whether lenders need to escrow these payments.
For example, if you’re buying a $350,000 home, your prepaid cost could range from $7,000 to $17,500. It is important to budget as these costs can increase quickly.
Pro Tip: Closed later in the month will help reduce your interest in advance as there are fewer advances. This saves hundreds of dollars. This is useful if you’re on a tight budget.
>>Read: How much money do you need to buy a house?
How to estimate prepaid costs
As mentioned before, prepaid costs usually fall between 2% and 5% of the home’s purchase price.
This is a quick breakdown of what you expect from each price.
Homeowner Insurance: Most lenders want to pay upfront amounts of 6-12 months. So if your annual premium is $1,200, you’ll probably pay upfront somewhere between $1,200 and $2,400 when closed. Property Tax: These vary depending on where you live and when you close. An easy way to estimate: Take the annual tax bill, divide it by 365 and multiply the deadline and the number of days before the next tax period. Mortgage Interest: First full payment is not scheduled until the following month, but we will start increasing closing days. Therefore, if you close in the middle of the month, you will pay your interest prepaid on the other day. Escrow Account Fund: If your lender sets up an escrow account (in most cases), you will likely require you to pay upfront months of property taxes and insurance. It’s just a buffer that ensures that these invoices are paid on time.
Closure and prepaid costs
Closure costs and prepaid costs are not the same. Knowing the differences will help you budget for closing days.
Closure fees are one-time fees paid to third parties for services related to the purchase of a home. On the other hand, prepaid costs are future housing expenses that you have paid upfront.
Let’s take a closer look:
Closing prepaid prepaid costs paid once when closing up any upcoming recurring expenses such as taxes and insurance may include loans, title insurance, valuation fees and recording fees. Property taxes, homeowner insurance, advance interest, escrow funds, and PMI cover services may cover the services needed to process and finalize future homeowners.
What can you do to prepare?
Seek for an estimate early. Your lender will give you a loan estimate – don’t be afraid to look at it and ask questions. Shop for homeowner insurance. The rates vary, with lower premiums = lower prepaid costs. Spend time strategically closing. As the end of the month approaches, the interest on advances will be lower. A budget of more than a down payment. It’s easy to forget how much these extras are added.
FAQ: Prepaid costs when buying a house
What is prepaid cost?
Prepaid costs are prepaid expenses paid when closing property taxes, homeowner insurance, mortgage interest, escrow funds, and more. These payments cover any bills scheduled after you have acquired ownership, ensuring your home and loan are protected from day one.
Why do I need to pay them?
Lenders will need these expenses to ensure that important invoices, such as taxes and insurance, are paid on time, even before the initial mortgage payment expires. This helps to avoid missed payments and give everyone a sense of security.
How much does it cost?
Prepaid costs typically run between 2% and 5% of the home price. For example, a $350,000 home might pay in the range of $7,000 to $17,500. The exact amount depends on deadline date, local tax, premiums and escrow requirements.
Where is the prepaid cost?
You can find the prepaid costs listed in Loan Estimates and Closure Disclosure. These documents will break down exactly what you are responsible for when you close. Scan and don’t emphasize if you don’t know what. Your lender or agent will help you explain the details and make sure everything is summed up.
