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Prepaid costs are future homeownership expenses you pay in advance at closing to ensure essential bills like property taxes and insurance are covered. Unlike one-time closing costs for services, these are prepayments for ongoing expenses held in an escrow account—a third-party account that manages payments on your behalf. A 2024 industry survey indicated that a significant majority of homebuyers are surprised by these costs, making it essential to understand what they are and how they are calculated. This guide will explain the common types of prepaid costs, how they differ from standard closing costs, and provide methods for estimating your total.
Prepaid costs generally include homeowners insurance, mortgage insurance, property taxes, and mortgage interest. Lenders require these payments to protect their investment and ensure you have a financial cushion for upcoming bills.
Homeowners Insurance: Lenders typically require you to prepay the first year of your homeowners insurance premium. This insurance protects both your and the lender's financial interest in the property against damage from events like fire or storms. Based on our experience assessment, lenders often prefer a full 12-month payment, though some may accept less if you have substantial cash reserves.
Mortgage Insurance: If your down payment is less than 20% on a conventional loan, you will likely pay Private Mortgage Insurance (PMI). It's common to pay the first two months of PMI upfront. For an FHA loan, an Upfront Mortgage Insurance Premium (UPMIP) of 1.75% of the loan amount is required at closing, regardless of your down payment.
Prepaid Mortgage Interest: You will pay interest from your closing date until the end of the month. For example, if you close on the 15th of a 30-day month, you will prepay 15 days of interest. This ensures your first regular mortgage payment begins on the first of the following full month.
Property Taxes: Lenders require you to fund an escrow account with enough money to cover future property tax bills. The amount prepaid depends on when you close relative to your county's tax due dates. Closing earlier in the tax year means a larger initial deposit into escrow.
The table below summarizes these common prepaid items:
| Prepaid Cost | Typical Requirement | Purpose |
|---|---|---|
| Homeowners Insurance | Up to 12 months premium | Protects the property against damage |
| Mortgage Insurance (PMI/MIP) | 1-2 months premium or 1.75% of loan (FHA) | Protects the lender if the borrower defaults |
| Property Taxes | Varies by closing date; enough to cover next bill | Ensures county tax obligations are met |
| Mortgage Interest | Interest from closing date to month's end | Covers the partial month of ownership |
While both are paid at the closing table, prepaid costs and closing costs are distinct. Prepaid costs are advance payments for your recurring homeownership expenses. In contrast, closing costs are fees for services rendered to finalize your mortgage, such as the home appraisal, title search, and origination fees.
A key difference is negotiation. A seller may agree to contribute to a buyer's closing costs as part of the sale negotiation. However, prepaid costs are almost always the buyer's responsibility because they directly fund the buyer's future obligations.
Prepaid costs can be estimated using publicly available information and simple calculations. Here’s how to approach the main categories.
Estimating Homeowners Insurance The average annual homeowners insurance premium is approximately 0.5% of the home's value. For a home priced at $400,000, the yearly premium would be around $2,000 ($400,000 x 0.005), or about $167 per month. To estimate your prepayment, multiply the monthly cost by the number of months your lender requires (often 12), resulting in an estimated $2,000 due at closing. Premiums vary based on location, home condition, and credit score.
Calculating Prepaid Mortgage Interest You can estimate this by determining your daily interest cost. For a $300,000 loan at a 4% annual interest rate, the yearly interest is $12,000. The daily interest is about $32.88 ($12,000 / 365 days). If you close on the 15th of a month, you would prepay interest for 16 days (from the 15th to the 30th), totaling approximately $526.
Projecting Property Tax Payments Property taxes are local, but you can find the previous year's tax bill for a property through county records or your real estate agent. Divide the annual tax amount by 12 to get a monthly figure. If you close in June and the lender requires a buffer, you might prepay several months of taxes into your escrow account.
To avoid surprises, review your Loan Estimate form carefully—prepaid costs are listed under “Other Costs” on page 2. Shop around for homeowners insurance to find a competitive rate, as this can lower your upfront cost. Finally, remember that while these costs are due at closing, they are essentially paying bills you would have owed anyway, and they help establish the escrow account that will manage these payments for you throughout the year.
