Mortgage closing costs vs. prepaids: what’s the difference?
Here’s what you need to pay and when
It is exciting when you finally find a home you love that also fits your budget. But unfortunately, that isn’t the only price tag you have to worry about in the mortgage process. You will also need to plan for mortgage closing costs as well as prepaids. Both are due before closing but cover different things.
Here’s the difference between the two and how much you should expect to spend on them.
Key insights
- Closing costs include the lender’s origination fee, title-related fees and appraisal and inspection fees.
- Prepaids are upfront costs paid at closing to cover future mortgage-related expenses, like insurance and taxes.
- Some closing costs may be negotiable or covered by the seller, depending on the lender and individual circumstances.
What are mortgage closing costs?
Mortgage closing costs are the fees and expenses that homebuyers need to pay when finalizing a mortgage loan. These fees are in addition to the down payment and will cost between 2% to 5% of your home’s sale price. Thankfully, some of these costs can be negotiated or covered by the seller.
“Closing costs typically include fees paid to the lender and third parties such as title companies and government offices for administering and processing the loan at the time of closing,” said Ron Goforth, senior vice president and director of product development at PNC Bank. “These may include an origination fee, appraisal and a title search fee.”
Here are the most common closing costs to budget for.
Loan origination fee
Title-related fees
Appraisal and inspection fees
Inspections are optional but highly recommended because they protect the buyer from costly repairs later on. Home inspections help rule out any potential issues or defects in a property before finalizing the purchase. It can also give you negotiating power after your offer is accepted if a major repair, such as of the roof or a heating, ventilation and air conditioning (HVAC) system, is needed.
How to calculate mortgage closing costs
Closing costs can vary widely depending on your lender and will include a mix of fixed and variable fees. But on average, you can expect them to equal about 2% to 5% of the home’s purchase price. So, if you purchased a $300,000 home, you could estimate your closing costs to range from $6,000 to $15,000.
Your lender will provide you with a Loan Estimate document that breaks down the fees and overall estimated closing costs for your loan.
What are mortgage prepaids?
Prepaid costs are upfront expenses paid at the time of closing and held in an escrow account until needed. These cover the first of your ongoing homeownership fees, such as property taxes and insurance.
“An escrow account is often established at closing for covering these ongoing expenses,” Goforth said. “Typically the lender will manage the escrow account and use the funds to pay these expenses on behalf of the borrower, ensuring timely payments.”
Property taxes
Homeowners insurance
You do have the option to choose which home insurance company you want to use.
Mortgage insurance
Some loan types, like a Federal Housing Administration (FHA) loan, come with a type of upfront and ongoing mortgage insurance premium that stays for the life of the loan.
Prepaid interest
» MORE: Mortgage APR vs. interest rate
How to calculate mortgage prepaids
You will receive your total of expected prepaids in your Loan Estimate document. It will include the following:
- Six to 12 months of homeowner insurance premiums: This ensures your insurance coverage is in place and adequately funded.
- Two months of property taxes: For instance, if your annual property tax bill amounts to $12,000, you would prepay $2,000 into an escrow account.
- Accrued interest: This is the interest that accrues on the loan from the closing date to the end of the month. To calculate this, divide your annual interest rate by 365 and multiply it by your loan amount. This is your daily interest rate and can then be multiplied by how many days it takes between closing and the end of the month.
FAQ
Can closing costs be negotiated or reduced?
Yes, closing costs can sometimes be negotiated or reduced. While some closing costs are fixed and non-negotiable, such as government recording fees, there may be other costs that can be negotiated with the lender or seller.
Can I roll closing costs and prepaids into the loan amount?
Depending on your lender, you might be allowed to roll some or all of the closing costs and prepaids into the loan amount. If your lender permits this, you might be stuck with a higher loan amount, monthly payment or interest rate. It might seem easier to roll $5,000 worth of closing costs into your loan, but paying interest on that amount for 30 years will be costly.
What happens if I can't afford to pay the closing costs or prepaids upfront?
Your lender will still be able to work with you if you cannot afford these closing costs and prepaids at the time of closing. You might qualify for local or state programs that cover these costs, or the lender can attach these costs to your loan.
Bottom line
Closing costs and prepaids need to be planned for and budgeted for before you head into closing. It's essential to review and understand these costs, as well as try to negotiate or reduce costs where possible.
While these fees can feel like another costly burden before you get your keys, they do make sure you are set during your first few months in your new home.
