Prepaid items are amounts that are required by the lender to be paid when a home purchase closes, in advance of their due dates. These may include:
mortgage insurance premiums
hazard insurance premiums
Most of these are not costs of borrowing. They are costs associated with home ownership. Amounts owed can be influenced by the closing date.
Prepaid Items Explained
Often, these payments are necessary to fund an impound account. Lenders often require borrowers, especially those with less than 20 percent down, to have impounds with their mortgage. This means the borrowers pay an additional amount each month to an account administered by the lender. When expenses like property taxes or homeowners insurance are due, the lender pays them on the borrower’s behalf.
This lowers the lender’s risk, because it can make sure the home is protected. If the taxes weren’t paid, a local government might take the property, and if insurance premiums were allowed to lapse, the home could be destroyed and the lender would have no collateral.
One of the prepaid items you are responsible for is accrued interest. This will vary depending on what time of the month you close your loan. One reason many people close at the end of the month is that it reduces the interest that accrues in advance of your first monthly mortgage payment.
If you close on the 15th of the month, for example, you will have to pay interest up front from the 15th to the end of the month. It’s a one-time charge: Once you have paid the portion of interest that accrued during the month of the purchase, your regular mortgage payments come due at the first of the month. The good news: If you close on the 15th of May, for example, your first mortgage payment isn’t due until July 1.
Private Mortgae Insurance Premium
If your down payment was less than 20 percent, another prepaid item will be your first month’s premium for private mortgage insurance (PMI), which protects the lender in case you can’t make your mortgage payments.
Hazard Insurance Premium
You may also be expected to prepay the first few months of your hazard insurance premiums. The money goes into an escrow account, which is set up by a third party, and is paid to the insurance company by your lender. You will need a receipt to show that you have prepaid this item.
Annual Property Tax Payment
Another prepaid item that goes into an escrow account is an amount equal to the first few months of your annual property tax payment. The amount to be prepaid is based on the previous year’s tax bill. Because tax rates often change annually, and because the tax value of your home can change with periodic reassessments, your actual annual tax bill could be higher or lower. Your mortgage payments will be adjusted accordingly if you continue paying property taxes through an escrow account.
Depending on a number of factors – the date of closing, the value of your home and the amount of the loan – prepaid items could represent a significant cost. Your lender and your real estate agent can help you estimate these costs ahead of time so you can be prepared to come up with the money for these prepaid items.