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Purchasing a new home isn’t always as straightforward as buyers would prefer. Aside from the home’s sale price, there are also a number of additional fees related to the transaction. Most buyers account for down payments and closing costs but can easily miss other costs, such as prepaid property tax.
Reputable mortgage lenders will do their best to break down each cost line by line in the loan estimate and mortgage disclosure documents. However, prepaid property taxes can still surprise many buyers, especially if they are unfamiliar with the home-buying process. This leaves buyers wondering, “What are prepaid costs when buying a home?”
Some buyers confuse prepaid costs with closing costs or escrow fees due to their similarities, but they’re actually three separate costs. Here’s what you need to know about prepaid property taxes.
What are Prepaid Costs When Buying a Home?
Prepaid property taxes are just one of several prepaid costs when buying a home. Lenders will ask buyers for prepaid costs to guarantee that expenses related to the property will get paid. Lenders then take these payments and put them in a prepaid escrow account for future payments. It’s important that lenders are able to make these payments. Failure to do so could result in a foreclosure.
Which Prepaid Costs Will Be Included In The Mortgage?
As mentioned above, prepaid costs are usually related to property taxes, mortgage interest, and homeowners insurance. However, prepaid costs vary by lender. When reviewing mortgage documents, look for the following line items.
Prepaid Property Taxes
Property taxes are based on the assessed value of the property at closing and your local tax rate. Your mortgage lender should give you an estimate of what your annual property taxes will be. Lenders may also require that property taxes be included in your monthly mortgage payment. If so, they’ll hold the funds in escrow throughout the year until they are due for payment.
The amount of prepaid property taxes you will have to pay depends on two factors: the time of year you are closing and the property tax payment schedule the previous owner was on. Depending on your state, property taxes are paid for either the previous or upcoming year.
Property Taxes for the Previous Year
If the seller paid their property taxes for the previous year in full, but is selling their home in July, they’d have to pay the new owner seven months of property taxes at closing. The new owner would only be responsible for the remaining five months of the year. A portion of these property taxes will be paid as prepaid costs at closing and the rest will be included in the mortgage payment.
Property Taxes for the Upcoming Year
If the seller paid property taxes for the year ahead of time and is selling in July, then the new owner would have to reimburse the seller five-months worth of property taxes for the year. The new owner would only be responsible for property taxes once a new annual cycle begins.
Prepaid Mortgage Interest
Mortgage interest is one of the most expensive aspects of buying a home, at least in the long-run. The amount of prepaid mortgage interest you’re responsible for paying at closing will depend on the terms of your mortgage, so it’s different for everyone. However, since prepaid interest is technically the interest that arises between the closing date and the end of the month, it’s advised buyers choose a closing day closer towards the 30th or 31st.
Prepaid Homeowners Insurance Premium
Homeowners insurance is required by most lenders. This is to ensure that your mortgage payments are met every month even if your new home requires repairs in the first year. Mortgage lenders usually ask for up to one year of homeowners insurance premiums in advance. Rates for homeowners insurance vary depending on the institution you purchase from.
Mortgage Insurance Premium (if necessary)
Unlike homeowners insurance, mortgage insurance isn’t always necessary. It’s easy to get them confused. A lender will normally require mortgage insurance if the buyer makes a down payment that’s less than 20%. Mortgage insurance premiums could be included in your prepaid costs if it’s being paid in a lump sum at closing. However, mortgage insurance is usually paid on a monthly basis along with your regular mortgage payment.
Specific Hazard Insurance
Locations that are prone to special hazards such as flood, earthquakes, or otherwise intense weather conditions may call for specific hazard insurance. If a lender requires a buyer to purchase flood insurance, for instance, the lender will collect one year of the insurance premium ahead of time and place it in escrow in the same way it would for homeowners insurance.
Prepaid Initial Escrow Payment
Also known as ‘earnest money’ or ‘a good faith deposit’, a prepaid escrow payment serves as a cushion for future expenses related to the mortgage. Not all lenders require it, but when they do, it’s usually on top of closing costs. Once the purchase is finalized, the lender can then use the money in the escrow account to pay homeowners insurance or other costs associated with owning the home in the event you are unable to make a payment.
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Where To Find Your Prepaid Costs On Your Loan
As you can see, there are quite a few prepaid costs associated with buying a home. If it’s your first time looking at a mortgage loan document, it can be difficult to identify where prepaid costs are listed. Now that you know what some of them are called, you can start looking for them on page two of your loan estimate.
They’re often titled “other costs” and come immediately after closing costs. If some of the line items don’t make sense to you, ask your lender to explain what exactly they cover. Property taxes, mortgage interest, and homeowners insurance will almost always be included as other costs.
What is the Difference Between Closing Costs & Prepaid Costs?
It’s easy to confuse prepaid costs with closing costs, but they’re two separate lines of business. Closing costs are fees for services rendered throughout the home buying process. They cover fees for lawyers, title companies, lenders, and appraisers.
On the other hand, prepaid costs are expenses related to actually owning the property. They’re expenses you would pay for anyway, your lender is just requiring you to pay them early.
Closing costs are paid to the lender for processing the loans. In some cases, the seller will pay for a portion of or all of the closing costs. Lenders can also cover closing costs, or at least give you a better rate for how much they charge. Prepaid expenses, however, will always be the responsibility of the buyer.
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The best way to think about closing costs and prepaid costs is to understand that closing costs are the costs of buying the property, while prepaid costs are the costs of owning the property.
Conclusion
Buying a new home is an exciting venture, but the process can get a bit overwhelming if you’re not prepared. Understanding all prepaid costs when buying a new home is a good place to start. Prepaid property taxes are just one of many prepaid costs that go into an escrow account. You’ll likely encounter prepaid homeowners insurance and mortgage interest, as well.
Buyers should also know the difference between closing costs and other costs. This is where buyers may end up paying for something they aren’t fully aware of. It’s important buyers are aware of what they are being charged.
If you want to move through the closing process with ease, make sure you hire one of the top real estate agents in your area. A reputable real estate agent will explain all costs and fees associated with your home purchase so that you can purchase your home with confidence.
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