Prepaids are expenses or items that the homebuyer pays at closing, before they are technically due. They are necessary to create an escrow account or to adjust the seller’s existing escrow account. Prepaids can include taxes, hazard insurance, private mortgage insurance and special assessments.
As an example, you may need to pay the first few months’ premiums for hazard insurance -- the portion of your homeowner’s insurance that covers losses from fire or other disasters, possibly including separate flood insurance. This and other prepaids protect the lender from losses right off the bat. The expense is considered prepaid because you are paying the premiums ahead of time.
Another one of your prepaids is likely to be private mortgage insurance (PMI). If you make a down payment of less than 20 percent, your lender probably will require you to purchase PMI, and you will usually have to pay the first few months of PMI ahead of time as one of your prepaids. Again, this upfront money protects the lender if something prevents you from making your mortgage payments early on.
Your prepaids may also include a portion of your property taxes, even if the tax bill isn’t due until later in the year. You will also have to pay any mortgage interest that would accrue from the day you close until the end of that month.
The money you put into prepaids goes into an escrow account established by a third party to hold the funds separate from the money you are paying in principal and interest. The third party makes the money from the prepaids available to the lender, which is responsible for making payments to the PMI carrier, hazard insurance carrier(s) and the local tax office.
You will continue to pay into the escrow account through your monthly mortgage payments. The lender will separate out the money that goes into escrow from your mortgage check, so you don’t have to write more than one check a month.