One group of costs that you will need to come up with at your loan closing is termed “prepaids”. Prepaids are those items that are considered part of the loan’s recurring costs. There are four prepaids that you will find at most closings.
The first is the prepaid interest in which you make an interest only payment for the days remaining in the month of closing. Most mortgage payments are due on the first day of the month for the preceding month. The first payment on your new loan will come due on the first of the month following the first full month after closing. For example a loan closing in March will have a first payment on May 1st. That payment made on May 1 covers the interest for the month of April. As part of the prepaids, if the loans closed on the 18th of the month, then the buyer would pay interest for the remaining 13 days in the month of March.
Most lenders initially estimate the interest that you will pay at closing at between 5 and 15 days. Using less than 30 days in the estimate but subsequently closing early in the month can increase the costs you need to close by hundreds of dollars over the initial estimate. I recommend that you use 30 days as the estimate. That way you are certain that the costs will not exceed the initial estimate and give you the knowledge that you have enough money to close.
The next prepaid is the homeowner’s insurance. The customer purchasing a house or site condo is required to have sufficient homeowner’s insurance to cover the amount of the mortgage. This can be done either by buying a dollar amount of coverage or with “replacement cost” coverage offered by most insurance companies. In either case the buyer is typically required to provide a paid one year’s homeowner’s insurance policy at the time of closing. Even if you have elected to pay the taxes and insurance yourself, the lender will still require a 1 year insurance policy to make sure that the home is insured against some calamity.
If the loan will include an escrow account for insurance, the lender will collect approximately two months’ worth of insurance premiums and deposit them into the escrow. Since the insurance policy is a one year term and because the first payment on the loan won’t occur for a month or two, the lender will only collect 10 house payments from the buyer before the annual insurance premium is due. The additional 2 payments collected at closing allow the lender to “jump start” the escrow so that there will be sufficient funds available to pay the first year’s insurance when it comes due.
Some lenders feel that the payment of the first year's premium is not a "lender's charge" and will omit that from their initial Loan Estimate. Personally, I think that this practice is outrageous and misleading. If you need to pay for something pertaining to the closing, that cost should be included in the total estimate even if the payment is made to another party. You don't want to end up paying several hundred dollars towards an insurance policy and then find yourself short on the remaining costs needed. When comparing estimates between lenders be sure that this has been included on all the estimates but remember that the actual amount you pay will be determined by you and your insurance company - not the lender.
The next prepaid is for property taxes and includes payments to the seller and the lender. In southeast Michigan the property taxes are paid in advance. (Most of the rest of Michigan they are paid in arrears. Let's concentrate on southeast Michigan in this article.) The city taxes usually become a lien on July 1st and the county taxes normally on December 1st. Both bills are for a full year. When the buyer closes on a house they reimburse the seller any taxes that have been paid in advance. This is called the “proration” of taxes and is calculated on a per day basis.
When the buyer has an escrow account for taxes they need to deposit enough money to pay the respective bills when they come due. Much like the escrow for insurance, the lender will calculate the number of monthly payments that they will receive before a tax payment is due and collect the difference. For example, if you will make 5 payments before a particular tax bill is due the lender will collect 7 months' worth of taxes for the escrow. This will insure that the lender has enough collected to make the annual payment. The federal government regulates how much money lenders are allowed to hold in escrow. This is called the aggregate analysis and is discussed in another area of this website. Normally the buyer will need between 10 and 13 months taxes at closing to cover both the prorations and escrow. I prefer to estimate the costs at 13 months so that there is a cushion in the initial estimate of charges. When comparing initial estimates be sure to see if the lenders are using the same number of months for taxes or the bottom lines could be dramatically different and you could be misled into thinking that a particular lender’s costs are less when in fact they are not.
The last prepaid involves those loans where there is some type of mortgage insurance. On certain types of mortgage insurance the premiums are paid much like the homeowner’s insurance. Subsequently, the lender may need to collect two months’ worth of mortgage insurance premiums from the buyer to make sure that there are adequate funds to pay the premium when it comes due. There are too many options for PMI to go into a full detail of them here.
By law every customer that applies for a mortgage must be given a Loan Estimate. This estimate is designed to show all of the costs that the borrower will incur to get a mortgage. Despite recent federal regulatory changes, there is a great deal of latitude that a lender can exercise in these Loan Estimates. I have seen estimates for the same mortgage where the bottom line has varied by hundreds of dollars due to different ways of estimating. Be sure that you understand the estimate before committing to a particular lender.
Since often comparing companies and quotes can be a daunting task, as a service to my clients, I help decipher the differences in Loan Estimates. If a detailed analysis shows that my costs represent the best then I help the person get their loan, if I am not the best available, then I’ll share that with the customer and they are free to pursue the loan through another lender.
An estimate where the loan officer has underestimated the costs may be a good predictor whether that loan officer can be trusted in the rest of what they say. Remember that according to federal regulations you cannot be made to pay costs that have not been disclosed to you prior to the closing. However, the costs must be those charged by the lender. Therefore if the lender fails to disclose title company charges, insurance, taxes or other charges associated to other parties, they are able to charge those after all.