What are Prepaids in Real Estate? Prepaids Explained

There are many terms used in real estate transactions that could cause confusion, and one of these is “prepaids.” Prepaids are expenses you pay in advance when you buy a home. They appear as a separate category on your Loan Estimate and Closing Disclosure, distinct from loan costs and the initial escrow payment. They’re one of the hidden costs of buying a home that catches a lot of buyers off guard, especially first-time buyers who budgeted for the down payment and closing costs but didn’t plan for this.

But what are prepaids in real estate, and what do you need to know about them?

What Exactly are Prepaids in Real Estate?

Prepaids are expenses you pay in advance at closing, mainly your prepaid mortgage interest and your first homeowners insurance premium, and in some cases a portion of your property taxes. On your Loan Estimate and Closing Disclosure, these are listed under a section labeled “Prepaids.”

Prepaids are often confused with your escrow account, but they aren’t the same thing. Your Closing Disclosure actually separates them into two different sections: Prepaids, and Initial Escrow Payment at Closing. The initial escrow payment is the money your lender collects at closing to fund the reserve account it will use to pay your future property tax and insurance bills. Some of your prepaid items, like your first insurance premium, may also flow into that same reserve account, which is part of why the two get confused so often.

Whether you’re required to escrow your property taxes and insurance depends on your loan program and lender, not simply whether you put 20% down. Some lenders require an escrow account regardless of your down payment, while others may allow you to waive it if you meet their requirements. A 20% down payment is much more commonly associated with avoiding private mortgage insurance than with avoiding escrow.

Prepaids vs Initial Escrow Payment

Since this is the part that trips up most buyers, here’s the distinction in plain terms.

Prepaids are amounts you pay in advance at closing for certain expenses associated with buying and financing the home. These typically include:

• Prepaid mortgage interest, the daily interest that accrues between your closing date and the start of your first full payment cycle
• Your homeowners insurance premium, often 6 to 12 months’ worth, paid upfront
• Mortgage insurance premium, if it’s collected as a lump sum rather than monthly
• In some cases, a portion of property taxes, depending on your closing date and local tax schedule

Initial escrow payment is separate. It’s the reserve deposit your lender collects to establish your ongoing escrow account, the account that will pay your future recurring property tax and insurance bills. That reserve is typically a cushion of a few months’ worth of these recurring charges, not a one-time expense the way most prepaids are.

Not every dollar you’re paying toward taxes or insurance at closing is technically a “prepaid.” Some of it may be your initial escrow deposit instead, which is why the two sections are disclosed separately.

How Do Escrow Accounts Work?

The mortgage borrower has the responsibility to pay into the escrow account, so the lender can use this money to pay insurance premiums and property taxes. The lender, or whoever is servicing the loan, will then ensure that these payments are made on time.

It doesn’t matter whether you use an escrow service or a title company during closing, the escrow account will be created anyway if your loan requires one. When this account is set up, it will need to be funded with your initial escrow payment. Afterward, part of your mortgage payment will go into this escrow account each month.

You will continue to pay your property taxes and homeowners insurance like this until you sell your home, pay off the loan, or your lender approves a request to waive escrow.

How Are Prepaids Calculated?

After you have applied for a mortgage with your lender, they will give you a Loan Estimate. This document should tell you all the information you need to know about how much you will be paying for your mortgage, including the lender’s fees, prepaids, and any initial escrow amount, based on estimates at that point in the process. The lender is required to give this to you within 3 business days of your loan application.

The lender has to estimate what your property taxes and insurance premiums will be. For property taxes, the lender will use the most recent assessment, though this may not be as accurate as you might want because taxes get reassessed. Insurance premiums also have to be estimated, since the insurance company, not the lender, ultimately sets the actual premium.

The Closing Disclosure is another important document you’ll receive, generally at least 3 business days before closing. It should repeat the same categories as the Loan Estimate, though the exact numbers may differ. A few things can cause that difference, like choosing a different homeowners insurance policy than what was originally estimated, or a change in your closing date.

Where Do Prepaids Appear on the Closing Disclosure?

When you receive your Closing Disclosure, look for the section labeled “Prepaids.” This is separate from the section labeled “Initial Escrow Payment at Closing,” which sits right below it. The Prepaids section can include items such as homeowners insurance, prepaid interest, and in some cases property taxes, mortgage insurance, or flood insurance if those apply to your loan. The Initial Escrow Payment section shows the money being collected to establish your escrow account for future recurring bills. Knowing which section you’re looking at makes the document much easier to follow.

What is Covered by Prepaids?

The most common prepaids you’ll encounter when buying a home are prepaid mortgage interest, homeowners insurance, and in some cases a portion of property taxes. Depending on your loan and property, other prepaid items can apply too, such as mortgage insurance or flood insurance. Let’s look at the main ones in more detail.

Property Taxes

Property taxes can show up in two different ways at closing, and it’s worth knowing the difference.

The first is a proration between buyer and seller. Property taxes are billed for the full year, but the buyer and seller generally divide responsibility for that year’s taxes based on the portion of the year each owned the property. At closing, you’re typically credited for the seller’s share of the annual tax bill for the time before you owned the property, an adjustment that happens between buyer and seller and isn’t part of your prepaids or escrow at all.

The second is your escrow reserve for property taxes. If your loan requires escrow, your lender will collect a cushion of a few months’ worth of property taxes upfront to fund that account, so it has enough on hand by the time your actual tax bill comes due. How much is needed depends on how far into the tax year your closing falls.

These are two separate things happening at the same closing, which is part of why property taxes are one of the more confusing line items for buyers.

Homeowners Insurance

Homeowners insurance is one prepaid where you have real control. You can shop around for coverage, and premiums can vary quite a bit between carriers, which affects your monthly and upfront costs alike.

It’s common for lenders to require 6 to 12 months of homeowners insurance to be paid at or before closing, though the exact number depends on your lender and policy. On top of that, if your loan requires escrow, the lender will typically also collect a few additional months of premium as a cushion for your escrow reserve.

Keep in mind that your lender’s estimate isn’t the final word on your premium, since the insurance company sets the actual cost, not the lender. In South Florida especially, homeowners insurance can end up being one of the largest pieces of your cash to close, so it’s worth getting quotes early rather than waiting until you’re under contract.

Mortgage Interest

When you close on the home, your first monthly mortgage payment isn’t due until the start of the next full payment cycle. Your lender will still want you to pay the interest owed for the days you’ve already been living in the home before that first payment, which is why this is collected upfront as prepaid interest at closing, rather than through your escrow account.

The size of this payment depends on how many days there are between your closing date and the start of your first payment cycle. Closing later in the month generally means fewer of those days, which reduces your prepaid interest. That said, prepaid interest shouldn’t be the only factor in choosing a closing date. Your rate lock, the seller’s timeline, and your own moving logistics all matter too, so it’s worth weighing this alongside those other factors with your agent and lender rather than optimizing for it alone.

Not Every Cost at Closing is a Prepaid

While there are other costs you’ll pay at closing, they aren’t prepaids. There are fees to arrange the mortgage, and other costs related to the purchase that can look similar to prepaids at first glance, but aren’t.

• Closing costs are the broader collection of expenses tied to getting your mortgage and completing the transaction. They can include lender charges, appraisal fees, title-related costs, government recording and transfer fees, and other third-party services. Many of these are largely fixed, though your seller may be willing to contribute toward them through a seller concession. See who pays closing costs for a full breakdown of what’s typically included and who’s responsible for what.
• Out-of-pocket costs, like your down payment, earnest money deposit, and home inspection, tend to have more flexibility, especially outside a strong seller’s market. It’s also worth shopping around for a lender, since fees and requirements vary.

As your finances are normally stretched when buying a home, anything you can do to reduce your expenses is helpful. If you want the full picture of what you’ll need to bring to closing beyond just prepaids, how much money you need to buy a house breaks down every piece, from the down payment to moving costs.

Example: What Prepaids Might Look Like at Closing

Say you’re buying a home with a mortgage and closing on the 20th of the month. At closing, your lender may collect:

• Prepaid interest for the remaining days left in that month
• Your homeowners insurance premium, typically 6 to 12 months’ worth
• An initial escrow deposit for future property taxes
• An initial escrow deposit for future homeowners insurance

Notice that the prepaid interest and homeowners insurance are prepaids, while the escrow deposits are separate. Property taxes can sometimes appear in either the Prepaids or Initial Escrow Payment at Closing section, depending on what the specific payment is for, which is part of why this line item causes so much confusion. The exact amounts will depend on your loan, your insurance premium, your local property tax schedule, and your lender’s specific escrow requirements.

Frequently Asked Questions

What are prepaids in real estate? Prepaids are expenses paid in advance at closing, mainly your first year of homeowners insurance and prepaid mortgage interest, and in some cases a portion of property taxes. They’re listed in their own section on your Closing Disclosure, separate from closing costs and from your initial escrow payment.

Are prepaids the same as closing costs? No. Closing costs cover fees to originate and process your loan and complete the transaction, like appraisal, title, and lender fees. Prepaids are a separate category covering costs paid in advance, like insurance and mortgage interest, even though both are paid at the same closing.

Are prepaid mortgage interest and escrow the same thing? No. Prepaid interest is a one-time charge for the days between closing and your first mortgage payment. Your escrow account is an ongoing reserve your lender uses to pay recurring property tax and insurance bills, funded initially through your Initial Escrow Payment at Closing.

Do I have to pay prepaids if I put 20% down? Prepaid mortgage interest applies to any mortgage regardless of your down payment, since it simply covers interest already owed. Whether you’re required to escrow property taxes and insurance depends on your loan and lender, not simply whether you’ve reached 20% down, though some lenders do allow buyers with more equity to waive escrow.

How much should I budget for prepaids when buying a house? There’s no standard amount. Your prepaid costs depend on your purchase price, property tax bill, insurance premium, loan terms, and closing date. Your lender will estimate these on your Loan Estimate and update them on your Closing Disclosure. In Florida, homeowners insurance in particular can make a noticeably large difference in the cash you need at closing, so get quotes early.

Can I reduce my prepaid costs? You have real control over your homeowners insurance premium by shopping around for coverage. Closing later in the month can also reduce your prepaid interest, since fewer days will have accrued before your first payment, though your closing date should be weighed against other factors too.

Do cash buyers have prepaids? Not in the traditional sense. Without a mortgage lender, there’s no prepaid interest or lender-required escrow account. Cash buyers still deal with property tax prorations at closing, however, and while there’s no lender requiring homeowners insurance, an HOA or condo association may have its own insurance requirements, so it’s worth checking.

Final Thoughts

There are many expenses to pay when you are buying a home, and prepaids are one that you might be required to pay when getting a home loan. While no one likes paying taxes or insurance ahead of time, prepaids and escrow reserves exist to make sure those bills get paid on time, so understanding the difference between the two can save you a lot of confusion when you’re staring at your Closing Disclosure.

If you are a first-time buyer, you might be surprised at the expenses you need to cover when buying a home. Planning for prepaids well in advance, alongside your down payment and closing costs, will help you avoid last-minute surprises at the closing table.

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About the Author

Top Wellington Realtor, Michelle Gibson, wrote: “What Exactly are Prepaids in Real Estate? Prepaids Explained”

Michelle has been specializing in residential real estate since 2001 throughout Wellington Florida and the surrounding area. Whether you’re looking to buy, sell or rent she will guide you through the entire real estate transaction. If you’re ready to put Michelle’s knowledge and expertise to work for you call or e-mail her today.

Areas of service include Wellington, Lake Worth, Royal Palm Beach, Boynton Beach, West Palm Beach, Loxahatchee, Greenacres, and more.