When you close on your mortgage, you’ll pay many fees, each of which has different names. Two of the most common expenses are prepaid costs and closing costs. Even though the closing agent collects both expenses at the closing, they mean different things.
Keep reading to learn about the difference between prepaid items and closing costs. You’ll understand the mortgage process better and find the loan that’s right for you.
What’s Included in Prepaid Items?
Prepaid items, as the name suggests, are costs paid before they are due. Prepaids have nothing to do with closing costs themselves. Instead, they are costs that pertain to the home. The three prepaid costs most buyers pay are:
- Homeowner’s insurance
- Real estate taxes
- Mortgage insurance
Lenders collect money for your homeowner’s insurance and real estate taxes to put in your escrow account. When the bill becomes due, the lender pays the bills for you out of the money in your escrow account.
Prepaid interest is the interest that you’ll accrue for the remainder of the month that you close your loan. Let’s say that you close on December 15th. You’ll owe the interest for the remainder of the month because your first payment isn’t due until February 1st. That February 1st payment will cover the interest for January, which leaves December’s interest uncovered.
How are Prepaid Items Calculated?
Lenders figure out how much you owe for prepaid items based on two factors:
- Your closing date
- The due date of the real estate taxes or homeowner’s insurance
Typically, borrowers need to pay for one full year of homeowner’s insurance upfront. If you provide a paid-in-full receipt for insurance, most lenders only require a buffer of 2 months of homeowner’s insurance though.
Real estate taxes are a different story. Lenders look at the due date for your real estate taxes to determine how much you must pay upfront. For example, if you close in October and real estate taxes are due in November, lenders need the full amount of the taxes upfront. If you close in October and taxes aren’t due until June, though, lenders may only ask for a 2-month buffer. The lender will also figure in any seller credit you’ll receive for the taxes before determining how much you need to pay at the closing.
What’s Included in Closing Costs?
Closing costs are the costs the lender and all third parties charge to process/close your loan. Some of the most common closing costs include:
- Credit report
- Closing fee
- Document fee
- Origination points
- Discount points
Any fees charged by the lender or a third-party to process or work on your loan fall under the closing cost category. Most borrowers pay an average of 3% to 5% of the loan amount in closing costs.
How are Closing Costs Calculated?
Each lender changes a different amount of closing costs. While there are some regulations regarding the maximum amount lenders charge, you’ll find different costs from lender to lender. We suggest applying with at least three lenders to get an idea of the average costs for your loan.
When you have multiple quotes, compare the quotes side-by-side. Look at the closing costs as well as the interest rate charged. Sometimes paying more closing costs is worth it if the lender will provide a lower interest rate. But, if you won’t live in the home for a long time, you may be better off paying fewer closing costs and taking a higher interest rate.
Can Sellers Contribute to Prepaid Items and Closing Costs?
In most cases, sellers can contribute to your prepaid and closing costs. Each loan has a maximum amount the seller can contribute:
- FHA – Up to 6% of the sales price
- VA – Up to 4% of the sales price
- Conventional – Up to 3% of the sales price (Unless you put more than 10% down then it increases)
Can you Get a No-Closing Cost Loan?
Some lenders do offer what’s called a no-closing cost loan. The name is deceiving, though. Yes, you don’t pay closing costs, but you do get a higher interest rate. The lender makes up the money they don’t make from the closing costs with the higher interest rate charged.
Lenders typically a 0.5% higher interest rate for a no closing cost loan. If you plan to stay in the home for the long-term, that higher interest rate could cost you thousands of dollars. If, however, your plans to live in the home are short-term, taking the higher interest rate and not paying closing costs could work out in your favor.
Prepaid items and closing costs are both costs you must cover when you take out a mortgage. While the prepaid costs will be the same with each lender (for the most part), the closing costs vary by lender. Shop around and find the loan that gives you the perfect balance between the right interest rate and the best closing costs.