When purchasing a home, buyers are responsible for paying closing costs and prepaids. The difference between the two can often be confusing, especially since they are paid when closing on a home purchase.
Here’s what you need to know so you’re prepared for closing day.
Closing Costs vs. Prepaids: What’s the Difference?
You might hear the terms “closing costs” and “prepaids” used interchangeably, but they are distinctly different.
“Closing costs” is a general term for all the charges and fees related to originating and closing on your mortgage. They include payments to the title company, the mortgage lender, and government entities. Depending on the type of mortgage loan, the seller might agree to cover some or all of the closing costs.
Typical closing costs include:
- Lender’s appraisal fee.
- Final credit report fee.
- Loan origination fee.
- Recording fee.
- Title search fee.
- Transfer taxes.
- Underwriting fee.
“Prepaids,” as the name suggests, are upfront costs for expenses. They are related to your new home, not the real estate transaction. Prepaids are not closing costs or fees. Instead, they are your funds being put into an escrow account to pay for insurance and taxes. Your lender “parks” these funds in an escrow account and uses them to pay the monthly bills typical of homeownership.
Prepaids are like paying car insurance premiums or cellular service at the beginning of each month. Some common prepaids are:
- Mortgage interest.
- Real estate taxes.
- Homeowners insurance.
- Hazard insurance.
- Private mortgage insurance.
- Special assessments typically related to real estate taxes.
Managing Mortgage Prepaids
The first mortgage payment is due one full month after the last day of the month in which the home purchase closed. Because mortgage payments are paid in arrears (paid for the previous month), many think the first month’s mortgage interest is “skipped.”
For example, if the closing is on June 16th, prepaid interest collected at closing is for the period of time between your mortgage closing date and the date of your first payment. Therefore, no mortgage interest payment is “skipped” because it was prepaid at closing.
To keep prepaids and closing costs as low as possible, you can compare and negotiate lender fees and ask the seller to contribute. Another way is to try to arrange the closing as near the end of the month as possible. With fewer days between closing and the start of the new month, the interest paid at closing will be less.
Time to Close!
Prepaids and closing costs are significantly different. It is important to remember when planning on buying a home that not only do you need to budget for the down payment and monthly payments, but you need money for the closing costs and prepaids. Understanding the complete picture puts you in control of your finances and ensures an enjoyable homebuying experience!
If you have any questions about prepaids and closing costs, your real estate agent is there to answer them. Your agent can help you negotiate, reduce, or, in some cases, eliminate some or all of your closing costs and many other homebuying options.
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