Purchasing a home is one of the biggest investments you'll make in your lifetime. Making this decision requires a lot of careful planning and effort. But being a good homeowner doesn't stop after you sign on that dotted line. Managing your home loan is a big ongoing responsibility. If you simply ignore your loan over the course of owning your home you could cost yourself thousands of dollars.
But going through the home loan process can be overwhelming. Tons of paperwork, fees and jargon. One of the more confusing items that come up during the refinance process is the difference between prepaid items and escrow at closing.
It's easy to just lump all the fees associated with refinancing a mortgage into the closing costs bucket. But there are different categories of expenses. If you looked at your HUD-1 statement before closing you would see that other categories outside of closing costs exist. Two common categories of expenses are "reserves" and "monies paid in advance" a.k.a. prepaid items.
Prepaid items are related to the home itself. The most common prepaid items related to mortgages are:
- Mortgage interest that accrues between closing and the end of the month. This is collected so the lender can put it towards your first mortgage payment which generally falls on the first of the month.
- Advance premiums for homeowner's insurance, hazard insurance and mortgage insurance if required. These items are paid by an escrow account funded by you as the homeowner.
- Advance payments for real estate taxes. Also paid by an escrow account funded by you.
The Difference Between Prepaid Items and Escrow
Any insurance premiums and taxes are paid into an escrow account. These are expenses that have to be paid no matter what so they are not really closing costs. The escrow account is just a holding account for the money that will be used by the lender to pay the insurance premiums and taxes. It's there to protect the lender. In the event that you stop making payments your lender will want to have enough money in the escrow account to pay the insurance and taxes.
This is why some lenders will ask you to pay escrow reserves. The calculation for reserves can differ across lenders. But an easy way to figure it out is to take the previous years expenses and divide by 12 to get a monthly amount then multiply the monthly amount by 2 to get a 2 month reserve amount.
It's also worth noting that prepaid items are always paid at closing but escrow accounts are not always required by the lender. If you are putting less than 20% down on a new home or have less than 20% equity in your home during a refinance the odds are good the lender will require an escrow account.
When you're going through the home loan process, for a purchase or refinance, don't be afraid to ask questions. You should understand all the fees and costs associated with your home loan. Your lender should provide you with a Good Faith Estimate so you can have an idea of costs before closing your loan.
Just prior to closing the escrow agent must also provide you with a settlement statement known as the HUD-1 which itemizes all final closing costs and fees associated with your home loan. Prepaid items are listed on a part of the HUD-1 in Section 900 entitled "Items Required by Lender to Be Paid in Advance". The escrow monies are in Section 1000 and are entitled "Reserves Deposited with Lender."
The key takeaways are that prepaid items are always present at closing. In most cases there will be some prepaid interest that has to be paid along with premiums for homeowners insurance. An escrow account is not always required by the lender but it is fairly common for people to have one. This is simply an account that you fund and that lender uses the money to pay insurance premiums and taxes.