Prepaids (At Closing)

Definition of Prepaids (At Closing):

Prepaids at closing are upfront costs that a borrower must pay as part of the mortgage closing process. These expenses are deposited into an escrow account and are intended to cover initial payments for property taxes, hazard insurance, and private mortgage insurance (PMI). Additionally, they include an allocation for interest accruing from the closing date to the end of the sorted month.

Detailed Explanation:

Prepaids at closing are held in escrow accounts — accounts managed by the lender or a third-party to ensure that critical property payments are made on time. These prepaid amounts typically cover the following:

Hazard Insurance: Insurance that protects the property against risks such as fire, storms, or other hazards.
Property Taxes: Taxes imposed by the local government on the assessed value of the property.
Private Mortgage Insurance (PMI): Insurance required when the borrower makes a down payment that is less than 20% of the property’s purchase price. PMI protects the lender if the borrower defaults on the loan.
Interest: Accrued interest from the was the loan closing date to the first mortgage payment date.

These prepayments help ensure that funds are readily available to cover significant expenses associated with homeownership, which protects both the lender and the borrower from the risk of default due to failure to pay these critical obligations.

Examples of Prepaids (At Closing):

Hazard Insurance Prepayments: If a borrower is required to prepay 14 months of hazard insurance and two months of real estate taxes at closing, this money is deposited into an escrow account. The funds later will be used to pay the annual insurance premium and property tax due.
Interest Prepayment: If a home loan closes in the middle of the month, the borrower may need to prepay the interest that will accrue from the closing date to the end of the month.

Frequently Asked Questions:

1. Why do lenders require prepaids at closing?
Lenders require prepaids at closing to ensure that there are sufficient funds to cover property taxes, insurance premiums, and other property-related expenses. This reduces the risk of default on these payments and ensures that the property remains insurable and free from liens due to unpaid taxes.

2. Are prepaids the same as closing costs?
No, prepaids are not the same as closing costs. While prepaids are specifically advance payments for taxes, insurance, and interests, closing costs include various fees for processing the loan, title searches, appraisals, and more.

3. How are prepaid amounts determined?
Prepaid amounts are typically calculated based on estimated tax bills, insurance premiums, and the number of days until the end of the month after closing. Your lender will provide a detailed breakdown of these amounts during the loan approval process.

4. Can I get a refund on prepaids?
Refunds of prepaid amounts generally do not happen while you own the home, as these funds are continuously used for taxes and insurance. However, any remaining balance in your escrow account might be refunded in case you sell the home or pay off the mortgage.

5. Do all loans require escrow accounts?
Not all loans require escrow accounts; however, many lenders will require one to minimize the risk of missed payments on essential expenses. This is especially true for loans with down payments less than 20% or loans for which the lender needs extra security.

Escrow Account: A secured account where funds for property-related expenses are kept, protecting both the lender’s and borrower’s interests.
Private Mortgage Insurance (PMI): Insurance that protects the lender in case the borrower defaults on the loan.
Closing Costs: Various fees and expenses paid by the borrower during the closing of a real estate transaction, separate from prepaids.
Hazard Insurance: Insurance that protects against damages from hazards like storms, fires, or other natural disasters.
Property Taxes: Taxes levied by the government based on the property’s value, which are due annually or biannually.

Online Resources:

References:

U.S. Department of Housing and Urban Development (HUD)
Consumer Financial Protection Bureau (CFPB)
BankRate Financial Education resources

Suggested Books for Further Studies:

“Home Buying Kit For Dummies” by Eric Tyson & Ray Brown
“The Mortgage Encyclopedia: The Authoritative Guide to MortgagePrograms, Practices, Prices, and Pitfalls, Second Edition” by Jack Guttentag
“Nolo’s Essential Guide to Buying Your First Home” by Ilona Bray, Alayna Schroeder, et al.

Real Estate Basics: Prepaids (At Closing) Fundamentals Quiz

### Why do lenders require prepaids at closing? - [ ] As a form of additional profit. - [x] To ensure that there are sufficient funds for taxes and insurance. - [ ] To pay real estate agents. - [ ] To pay for property renovations. > **Explanation:** Lenders require prepaids to ensure that funds are available to cover necessary expenses like taxes and insurance, reducing the risk of missed payments. ### What is included as prepaid expenses at closing? - [ ] Only the down payment - [ ] Loan processing fees - [x] Hazard insurance, property taxes, and accrued interest - [ ] Home inspection fees > **Explanation:** Prepaid expenses typically include hazard insurance, property taxes, and accrued interest to cover costs from the closing date until the end of the month. ### What is the primary function of an escrow account in real estate? - [ ] To earn interest for the borrower - [x] To hold funds for taxes, insurance, and other property-related expenses - [ ] To pay for real estate agent commissions - [ ] To cover utility bills > **Explanation:** An escrow account primarily holds funds for property-related expenses like taxes and insurance to ensure that these payments are made on time. ### Are prepaids at closing a one-time expense? - [ ] Yes, they are paid once and never again. - [x] No, they are an advance payment for recurring expenses. - [ ] Yes, they are fixed and do not change. - [ ] No, only taxes are included. > **Explanation:** Prepaids are an advance payment for recurring expenses such as taxes and insurance, held in escrow to ensure ongoing payment. ### What are private mortgage insurance (PMI) prepaids at closing intended for? - [x] To protect the lender in case of borrower default - [ ] To protect the property from damage - [ ] To reduce the borrower's insurance premium - [ ] To provide borrower seed money > **Explanation:** PMI prepaids protect the lender in case the borrower defaults on loan, typically required when the down payment is less than 20%. ### How are prepaid amounts typically calculated? - [ ] Based solely on the estimated property value - [x] Based on estimated tax bills, insurance premiums, and accrued interest - [ ] Randomly chosen by the lender - [ ] Determined by local government regulations > **Explanation:** Prepaid amounts are typically calculated from estimated tax bills, insurance premiums, and the number of days' worth of interest accruing from the closing date. ### Can you get a refund on prepaids if you sell your home before the end of the escrow term? - [x] Yes, remaining amounts in the escrow may be refunded - [ ] No, prepaids are non-refundable - [ ] Only for the property taxes paid - [ ] Only if the home was insured > **Explanation:** If you sell your home or pay off your mortgage, any remaining amounts in the escrow account might be refunded to you. ### What distinguishes prepaids from closing costs? - [ ] Prepaids include the real estate agent’s commission. - [x] Prepaids are advance payments for future expenses like taxes, while closing costs encompass various fees involved in the loan process. - [ ] One is refundable while the other is not. - [ ] Prepaids are mandatory, but closing costs are optional. > **Explanation:** Prepaids are specifically advance payments for future expenses while closing costs cover fees for the transaction process itself. ### Who typically benefits from an escrow account? - [ ] Only the lender benefits. - [ ] Only the borrower benefits. - [x] Both the lender and the borrower benefit. - [ ] Real estate agents benefit. > **Explanation:** Both the lender and the borrower benefit since escrow accounts ensure critical payments like taxes and insurance are made on time. ### What happens to the prepaids if you refinance your mortgage? - [ ] They are forfeited. - [ ] They roll into the new mortgage. - [x] They are adjusted and used to update the new mortgage terms. - [ ] They are kept by the original lender. > **Explanation:** Prepaids are typically adjusted as part of the new mortgage terms during refinancing, ensuring proper accounting of taxes, insurance, and interest.