Mortgage Closing Costs vs. Prepaid Costs: What’s the Difference?

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 typically 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, former senior vice president and director of product development at PNC Bank.

Here are the most common closing costs to budget for:

Loan origination fees

Origination fees are administrative costs charged during the processing and underwriting of the mortgage loan. They’re typically between 0.5% and 1% of the loan amount.

Title-related fees

You’ll generally need to pay for a title search, title insurance and recording fees to verify the ownership of the property and ensure there are no legal issues or claims against it.

Appraisal fees

You’ll also need to pay for a home appraisal, which determines the fair market value of the property. An appraisal will also reveal if the property meets the mortgage lender's requirements, if any.

Home inspection fees

Home inspections help rule out any potential issues or defects in a property before finalizing the purchase. While generally optional, they can protect the buyer from costly repairs later on. They can also give you negotiating power if an inspection reveals that a major repair is needed, such as a new roof or a new heating, ventilation and air conditioning (HVAC) system.

» MORE: How to negotiate your mortgage closing costs

What are mortgage prepaid costs?

Prepaid costs are upfront expenses that are paid at closing and held in an escrow account until needed. These costs generally cover your first payments toward ongoing homeownership fees, such as property taxes and home insurance.

“An escrow account is often established at closing for covering these ongoing expenses,” Ron 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.”

Here are some prepaid costs to budget for:

Property taxes

Lenders may require borrowers to prepay a certain amount of property taxes at closing to ensure they are paid on time. Your actual property tax is based on the assessed value of your property.

Homeowners insurance

Homeowners insurance provides coverage for potential damage or loss to the property. Your lender will require that you have homeowners insurance coverage, and it may require you to pay an annual premium in advance at closing.

Mortgage insurance

If you put down less than 20% for a down payment, your lender will require you to have private mortgage insurance (PMI) for protection against a default. PMI can be removed when you have at least 20% equity established.

Prepaid interest

Prepaid interest refers to the interest that accrues on the mortgage loan between the closing date and when your first monthly mortgage payment is due.

» MORE: Mortgage APR vs. interest rate

Cost comparison: closing vs. prepaid costs

Total closing costs and prepaid costs will vary, and some costs can change by the closing date.

Closing costs

Closing costs can vary widely depending on your lender, and they’ll generally include a mix of fixed and variable fees. But you can typically expect them to equal about 2% to 5% of the home’s purchase price. So, if you purchase a $300,000 home, your closing costs will typically 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.

Prepaid costs

You’ll receive your expected prepaid costs in your loan estimate document. It will typically 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: Your loan will accrue interest from the closing date to the end of the month.

Bottom line

Closing costs and prepaid costs need to be planned for before you head into closing. It's essential to review and understand these costs, as well as to negotiate or reduce costs where possible. While these fees can feel like another costly burden before you get your keys, they make sure you’re set during your first few months in your new home.