Buying a home is expensive. This stands to reason, of course, but in addition to a down payment and closing costs, there are prepaid costs (or “prepaids”) wrapped into the transaction. Lenders do their best to outline all costs for you when you receive your loan estimate and mortgage disclosure documents, but if you don’t know what you’re looking for within these documents, prepaid costs can come as a surprise. 

In addition to a down payment and closing costs, prepaids are another expectation new homebuyers should keep in mind. Prepaid costs, closing costs, and escrow share similarities, but they're ultimately three separate entities.

Here’s what you need to know. 

What are prepaid costs?

Prepaids are payments made in advance of the money due (your down payment) to obtain a mortgage. They get their name because they’re paid at closing, which is before the fees are technically due.

The good news is, prepaid costs aren’t extra costs. In fact, they’re things like taxes and insurance that you’d be paying for regardless of whether you get a home loan or not. They're completely separate from your mortgage, although you’ll be paying them at the same time as your closing if you use a lender.

What’s the difference between prepaid costs and closing costs?

Closing costs have more to do with the actual process of originating and closing a mortgage loan. Typically, they include things like paying closing attorneys, paying any title companies, and covering any lender fees. 

We’ve outlined common prepaid costs below, but if you’re unsure, just ask yourself if you’d be paying for this particular item or service even if you weren’t obtaining a loan to buy the house. A good example is property taxes: Would you be paying for property taxes even if you didn’t have a lender? The answer is yes, thus making it a prepaid cost. 

What common prepaid costs can I expect?

Prepaid costs include the homeowner’s insurance premium, property taxes, and mortgage interest that you pay when you buy a home. As mentioned, prepaid costs would cost the same amount whether or not you have a lender and would be required whether or not you obtain a loan. However, they do increase how much money you'll need at closing.

Note: Mortgage interest refers to any interest that accrues between your closing date and the end of the month. Remember, mortgages are paid in arrears. That means for buyers, they’d pay less (potentially thousands of dollars less) in mortgage interest if they closed at the end of the month compared to the beginning of the month. Buyers have less upfront expenses by selecting a closing date at the beginning of the month because they’ll have to pay less interest on their mortgage. However, sellers typically prefer to close at the beginning of the month to receive their sales proceeds more quickly.

Where can I find prepaid costs outlined in my loan documents?

When you receive your loan estimate document, prepaid costs are usually in a section vaguely termed “other costs.” In your mortgage disclosure, prepaid costs are outlined in Section F, called “Prepaids,” and Section G, called “Initial Escrow Payment at Closing.” 

Are prepaids related to escrow?

Usually. Most lenders want you to use an escrow account to manage any insurance payments and tax payments. Basically, if you choose to use an escrow account, a portion of your monthly mortgage payment will go into that account. Then, your lender will pay your insurance and tax payments using the money in the escrow account. 

Lenders prefer using escrow accounts to prevent you from going without insurance or ignoring tax payments, which can ultimately increase the risk of loss for them, whether from a natural disaster or foreclosure. In fact, many lenders charge a fee if you waive an escrow account. Personally, I find having an escrow account a convenient option, but if you choose to waive it, know the fee is nominal—only about 0.25 percent of the loan amount. On a $250,000 loan, for example, that would be a fee of $625. 

If you do opt for an escrow account, here’s where prepaids come in: Rather than paying property taxes and insurance outright, you'll pay an initial escrow payment and your lender will deposit the insurance and tax portions into your escrow account. When the bills are due, your lender will handle tax and insurance payments for you using the money in your escrow account. Your mortgage insurance will still be a separate prepaid cost even if you use escrow. 

How do I compare prepaids when shopping for a mortgage?

As you review loan offers, you might notice that prepaids are different in the loan estimate documents you receive from competing lenders. While it might be tempting to pick the lender that lists lower prepaid costs, don’t.

Lenders simply make estimates (hence being called a “loan estimate” document); you’re the one who will ultimately be selecting a homeowner’s insurance provider and property, which will have specific property tax records based on your city and county. Remember: How much you actually pay at closing for your homeowner’s insurance premium and property taxes will be the same regardless of which lender you choose. Rather than focusing on prepaids, look at more important aspects of the loan offer—most notably interest rates, terms, and fees.

Prepaids can ultimately mean less money in your pocket at closing, but they’re items you’d be paying for whether you used a lender or not.