Buying a home is one of the big investments for anyone that takes a sizeable chunk of their savings in one go. Mortgage companies often highlight the estimated prepaid loan costs; the additional charges and deposits often trouble many. These initial costs might overwhelm you, but the fact is that it reduces your monthly mortgage payment and, eventually, your mortgage closing costs.
Prepaids are the borrower’s funds taken in advance against certain mortgage expenses before they are due. The prepaid costs go into the Escrow account and assure the lender/mortgage provider of regular payment of monthly expenses. This can be assumed as a monthly cost of homeownership.
What is the Prepaid Cost When Buying a Home?
Prepaid costs are the upfront payments made before the down payment to secure your mortgage for the home. Prepaids are future home-related expenses, including property taxes, homeowners’ insurance, prorated mortgage interest, and other escrow payments. Mortgage companies anticipate prepaid costs in a loan estimate and closing disclosure. If you dive deep into the prepaid costs, you can estimate your loan closing cost and check the affordability of your dream home.
Difference Between Closing Costs and Prepaid Costs
Sometimes, prepaid and closing costs are used interchangeably, though different. Prepaid cost includes interest, homeowners insurance, property taxes, mortgage insurance, or initial escrow deposits. This advance prepaid amount goes into an Escrow account and assures the lender/mortgage provider of the due payment if the borrower misses any payment. Closing costs are paid for third-party services during the closing of a home deal.
- Prepaid costs are taken from you but ultimately come to you in the Escrow account. While closing costs are gone to third parties.
- Prepaids are paid during the closing process while closing costs are the fee paid to third parties for administering and processing the loan. Closing cost includes paying for title companies, attorneys, document drafting, real estate commission, government fee, etc.
- Prepaid costs are the present expenses that secure the future. It adds value to your expenses and reduces your mortgage closing cost. Closing costs are additional expenses from your account to pay for third-party services. It increases your overall loan closing costs.
Prepaid Costs Are as Follows for Buying a Home
Before closing the home deal, you make certain mortgage expenses in advance that are saved as future payments of interest, taxes, and insurance. Mortgage companies typically outline prepaid costs in the mortgage loan estimate document. Planning for estimated prepaid expenses can make you relax during the monthly mortgage payment. Prepaid costs include:
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Homeowners Insurance Premiums
Homeowner insurance premium includes financial reimbursement for reconstruction and repair of your damaged property. It protects you from any damages caused by fire, theft, or mishaps. Mortgage lenders require homeowners insurance to protect their investments against damage coverage in your home. In the event of a fire, or severe weather damage, you can claim your home insurance policy to cover any losses.
Your lender collects 6-12 months of homeowners insurance premiums in advance as part of your closing costs. However, Homeowners insurance premiums can vary depending on your location, age, condition of your home, credit score, etc.
If your home is in a disaster-prone area, the lender may require you to take a specific hazard insurance policy separately. Or you might have to pay an increased insurance premium rate to get coverage under the risk attack. Once you close the house deal, the Escrow company will pay the premium to the insurance company for damage coverage of the home property.
The one full year of home insurance premium as a prepaid cost is broken up into 12 monthly mortgage payments and deposited into your Escrow account.
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Property Taxes
Property taxes are another prepaid expense that has to be paid in full and on time. The fund will go into the Escrow account until they are due.
Property taxes are based on the current assessed value of your property. You can calculate the property tax by multiplying the assessed value of your home with your local tax rate. How?
Also Read: 10 Things to Consider Before Buying Rental Property
First, calculate your prepaid property tax when closing the home. Multiply the assessed value by the number of days left in the year.
For example, if your annual property taxes are Rs 15,000 and there are 120 days left, divide $15,000 by 365. You’ll get Rs 41.095 for a day. Multiply Rs 41.095 by 120, and you’ll get a prepaid property tax a total of Rs 4931.50 for that year.
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Monthly Mortgage Interest
Mortgage interest fees are part of your prepaid costs and depend upon what time of month you have closed the home deal. The closer to the month-end you fix the deal, the less you’ll have to pay as monthly interest. The mortgage payment calculator calculates your monthly mortgage payment on different interest rates and helps you to choose a loan that best fits your needs.
To calculate your prepaid interest, first, take your annual interest rate and divide it by 365 days. Then multiply the daily interest amount by your home loan amount, and you will get the cost per day. Multiply the daily cost by the remaining days between the closing date and the last day of the month.
The prepaid mortgage interest goes into the Escrow account and will be paid on the due date as the first mortgage monthly payment.
Why Do Lenders Collect Prepaid Costs?
When you buy a home, you encounter three major expenses: Down payment, Prepaid expenses, and Closing costs. Down payment is the principal purchase price, closing costs are fees charged by a third party for the services, and prepaid costs are present expenses for future payment. Though Prepaid costs is an additional payment, it takes the burden off your shoulder. You can be stress-free during monthly mortgage payments as some of the mortgage is already handled through the Escrow account. It streamlines the process of monthly mortgage payments instead of carrying out separate payments or each item at a different time.
The initial Escrow payment is held with the lender until it’s due. Important to note that the money in the Escrow account belongs to the homeowner, but it assures lenders as well in case of failed payment.
Reason to Collect Escrow Deposit
Escrow accounts and Prepaid costs are closely related but different in functionality. An Escrow account is set up by your mortgage lender where the prepaid costs of the home loan are deposited. The Escrow account is a savings account for the house owner to take care of future taxes, interest, and insurance. After closing the home deal, the buyer’s earnest money is deposited into the Escrow account, which the lender uses for monthly payment of taxes and insurance. If the owner fails to make a payment, the lender could have enough money in the Escrow account to avoid the risk of missed payments. An Escrow account is a boon for both owner and lender! The Escrow deposits give the lender and owner peace of mind by securing some amount for future payment of insurance and taxes.
You can calculate your Escrow deposit and check your financial eligibility for a home loan. Mortgage companies give an estimate of prepaid cost document where you can identify the prepaid costs described in your loan. You can check initial Escrow deposits, insurance premiums, real estate property taxes, mortgage interest rates, and fees to calculate your prepaid loan cost.
Bottom Line
Buying a home and securing a mortgage is a complex process. The initial costs might give a setback, though It’s better to compare interest rates, terms, and fees when choosing a mortgage lender for your prepaid estimate. You can have the flexibility of taxes and interest rates based on government rules and location, further reducing your prepaid costs. Once you have all the theoretical knowledge of the prepaid costs, you can check your eligibility for the kind of property and home loan.
