What Are Prepaids On A Mortgage Loan

Prepaids on a mortgage loan are upfront costs that cover expenses like property taxes, homeowners insurance, and mortgage insurance. Typically, you’ll pay two months’ worth of property taxes and homeowners insurance at closing. For example, if your annual property tax is $3,600, you’d need to set aside $600 at closing. This ensures these bills are paid on time and protects both you and your lender.

Understanding Prepaids: What You Need to Know

What Are Prepaids?

Prepaids are costs associated with your mortgage that you pay in advance. They typically include property taxes, homeowners insurance, and mortgage insurance. These payments are essential to keep your home protected and ensure you stay on top of your financial obligations. When you close on your mortgage, lenders often require you to pay a portion of these costs upfront, which are then held in an escrow account to cover future payments.

For instance, if you buy a home for $300,000 with an annual property tax of 1%, you’re looking at $3,000 in yearly taxes or $250 monthly. Your lender might require two months’ worth of property taxes ($500) at closing, meaning you’ll prepay that amount to ensure your taxes are covered.

The Breakdown: Common Prepaids

Property Taxes

Property taxes are levied by local governments and can vary widely depending on where you live. They’re usually based on the assessed value of your home. As mentioned, if your home is valued at $300,000 and your local tax rate is 1%, you’d pay around $3,000 annually or $250 monthly. When closing, lenders may require two months’ worth, which would be $500.

Homeowners Insurance

Homeowners insurance protects your home and possessions against damage or theft. The premium for this insurance can depend on various factors, including the home’s value, location, and coverage amount. For example, if your policy costs $1,200 annually, you’d pay $100 monthly. At closing, you’d need to prepay two months’ worth, or $200.

Mortgage Insurance

If you put less than 20% down on your home, you’ll likely need to pay for mortgage insurance. This protects the lender in case you default on the loan. The cost can vary, but let’s say it’s $150 monthly for a $300,000 home. You’d need to prepay $300 for two months when closing.

Escrow Accounts

An escrow account is a separate account where your lender holds the funds for property taxes and insurance. After you make your monthly mortgage payment, a portion goes into the escrow account. When tax and insurance bills are due, the lender uses this account to pay them on your behalf. This ensures that you don’t fall behind on these important payments.

How Prepaids Affect Your Closing Costs

When you’re buying a home, prepaids get rolled into your closing costs. Closing costs can range from 2% to 5% of your loan amount. For a $300,000 home, that could mean anywhere from $6,000 to $15,000 in closing costs. Prepaids can significantly impact this total.

Let’s say your total closing costs add up to $10,000. If $2,000 of that is made up of prepaids (for taxes, insurance, etc.), you’ll need to come up with that amount at closing. This is why it’s essential to budget for prepaids when planning your home purchase.

Example Scenarios

Sarah’s Closing Costs

Sarah, a 35-year-old teacher in Denver, purchased a home for $400,000. Her annual property tax is 0.8%, which amounts to $3,200 or about $267 monthly. She also needs homeowners insurance, costing $1,500 annually, or $125 monthly. Since she’s putting down 10%, she has to pay mortgage insurance of around $200 monthly.

At closing, Sarah will need to pay:

• Property taxes (2 months): $534
• Homeowners insurance (2 months): $250
• Mortgage insurance (2 months): $400

Total prepaids: $1,184. If her total closing costs are $12,000, her prepaids represent about 9.87% of that total.

Mark’s New Home Purchase

Mark, a 28-year-old software developer in Austin, buys a home for $350,000. His annual property tax is 2%, so that’s $7,000 or about $583 monthly. His homeowners insurance is $1,200 annually or $100 monthly. Because he’s only putting down 5%, he needs mortgage insurance costing $180 monthly.

At closing, Mark will need to pay:

• Property taxes (2 months): $1,166
• Homeowners insurance (2 months): $200
• Mortgage insurance (2 months): $360

Total prepaids: $1,726. If his total closing costs are $11,000, his prepaids make up about 15.68% of the total.

How to Calculate Your Prepaids

Calculating your prepaids is straightforward, but it requires knowing the annual costs of your property taxes and insurance. Here’s a simple formula:

1. Calculate Monthly Costs:

   • Property Taxes: Annual amount / 12
   • Homeowners Insurance: Annual amount / 12
   • Mortgage Insurance: Monthly amount (if applicable)

2. Multiply by Two:

   • For property taxes and insurance, multiply your monthly amounts by two to find out how much you’ll need to prepay at closing.

3. Add It Up:

   • Sum all the prepaids to see your total cost.

FAQs About Prepaids on a Mortgage

1. What happens if I don’t have enough for prepaids at closing?

If you can’t cover your prepaids at closing, the lender may require you to pay them upfront or adjust your loan terms. It could also delay your closing date. Always ensure you budget for these expenses.

2. Can I roll prepaids into my mortgage?

Generally, prepaids can’t be rolled into your mortgage. They need to be paid upfront. However, some lenders may offer options to help with closing costs, but that typically doesn’t include prepaids.

3. How do I know how much my property taxes will be?

You can estimate your property taxes by checking local tax rates and recent assessments of similar homes in your area. Your real estate agent or lender can also provide guidance on what to expect.

4. Is homeowners insurance required?

Yes, most lenders require homeowners insurance to protect their investment. Even if it’s not legally mandated, it’s a smart choice to safeguard your home against potential disasters.

5. How often should I review my escrow account?

It’s a good idea to review your escrow account annually or when you receive your property tax and insurance bills. This way, you can ensure that you’re paying the correct amounts and adjust your monthly payments if necessary.

Conclusion: Next Steps for Homebuyers

Understanding prepaids is crucial when buying a home. They can significantly impact your closing costs, so it’s wise to budget for them upfront. Start by estimating your property taxes and insurance costs, and factor those into your savings plan for closing. Don’t hesitate to ask your lender for a breakdown of all costs involved to ensure you’re fully prepared.

By planning ahead and knowing what to expect, you can navigate the home-buying process with confidence. Whether you’re a first-time buyer or looking to move, being informed about prepaids will help you make better financial decisions.