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In this article we are going to explain the 3rd category of closing costs, Pre-Paid Items. Of the 4 closing cost categories this category is probably the 3rd most important.
Before we start explaining what pre-paid items are, there is one important fact that you should understand. Other than shopping for the lowest homeowners insurance premium, all of the other pre-paid items are determined by simple math forumlas and cannot be manipulated by your lender. The pre-paid category of your closing costs should be the same no matter what lender that you work with.
With that said, please don't mis-understand what I am saying, some lenders will under-estimate your pre-paid items to make their estimates look more attractive but since these lenders have no control of how much your pre-paid items really are they are not bound by that portion of their estimate. For this reason they sometimes underestimate your pre-paid items to make their overall estimate and monthly payment look lower than it really is.
We suggest that you learn how to calculate your own pre-paid items so that you can address any discrepancies on your estimates. Remember that your pre-paid items will end up being the same everywhere, so you can just ignore that section of any quotes that you receive.
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They are actually exactly what they sound like.... items that you are pre-paying for in advance.
Pre-Paid Items are one of the 4 total groups that make up your closing costs.
Before I go any further, I want to mention that there is a Pre-Paid Item calculator on this site that will do the calculations for you.
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1. Pre-Paid Interest
2. Pre-Paid HomeOwner's Insurance
3. Pre-Paid Taxes
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The short answer is yes and no..
All mortgage loans will require at least one day of Pre-Paid Interest. This will be explained better a little later.
As for the taxes it depends on if you are escrowing for your taxes and insurance. If you don't know what that means go read our Escrow article first and then come back to this article.
If you are escrowing for taxes and insurance then you will always have some pre-paid items at closing. The reason is because when you will never make 12 payments before the taxes and insurance become due.
For example lets say that you closed a new purchase on July 15th.
You would be required to pay the first year of homeowner's insurance at the closing. This would keep the insurance paid all the way up to July 15th of the next year and then the annual premium would be due again.
Since you get to skip a month after closing your first mortgage payment then would not be due until September the 1st. Based on that you would only make roughly 10 payments before the insurance would be due again. This means that you would not have enough money in the escrow account to pay the insurance. In order to make sure that this doesnt happen you will have to put an extra 2 months into the escrow account when you close your loan.
They also like to keep a 2 month cushion in your escrow account in case your taxes or insurance increase so you will actually put 4 months in at closing instead of 2 months. To sum up the pre-paid insurance requirements, on a purchase you will always have to pay the first year of homeowner's insurance at closing along with probably about 4 additional months of insurance to pre-fund your escrow account.
Taxes work the exact same way. For example if you closed again on July 15th
Since you get to skip a month after closing your first mortgage payment again would not be due until September the 1st.
Now in most states the property taxes are due In November or December, based on that you would only make roughly 2-3 payments before the taxes would be due again. In order to make sure that there is enough money to pay the property taxes you again must pre-fund this account at closing with 9-10 months to ensure that the funds are there in November when it is time to pay the taxes. They also like to keep a 2 month cushion in your escrow account for taxes as well so you will actually put 11-12 months in at closing depending on the due date.
We have created an easy Pre-Paid item calculator for you to help you calculate how many Pre-Paid months would be needed based on your closing date and the due date of the taxes and insurance.
That covers the basics of the Pre-Paids Items, escrows and what to expect at your closing.
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