Interest
Insurance
Taxes
Escrow Account

Now lets talk about those elusive Prepaid Items I so quickly glossed over on the Closing Costs page. It's important not to forget them because Prepaid Items can cost as much, if not more, than your Closing Costs.

Prepaids are the area a Lender is most likely to get wrong on their guesstimate of how much money you will need to bring to closing.
Why? Many prepaids are not fixed costs and some are even under your control. No, I am not trying to hedge my bets. For example - I don't know if you will shop diligently for the lowest cost insurance (we tell all our customers how) or whether you will pay top dollar plus buy $1,000,000 worth of coverage for your stamp collection.

Let me ask you a question, would you rather need less money at closing than I originally told you or more? I thought so! That is why our policy is when in doubt to calculate maximum costs instead of minimums. But there is no way we can anticipate the $1,000,000 worth of coverage on your stamp collection! Most of our customers go to closing and need less money than we originally told them. We fully disclose and feel that if you need to bring more than $200 extra to closing we have done something wrong.

Prepaid costs consist of Interest, Insurance, Taxes and sometimes Mortgage insurance. Lets examine each of these Prepaid Items:

 

INTEREST: You will pay interest from the day you close until the first day of the next month and your house payment won't be due until the first of the following month.

Why is this? Your house payment is made in arrears, not in advance like rent. This means that your October house payment is actually for the month of September.

To know how much interest to guesstimate for you I would need to know the exact day of the month you will be closing. To be safe we figure a full 30 days worth of interest. If you close on the 15th your interest figures will be half of what we tell you.

 

Let me give you the formula so you can figure your own Interest:

 

Loan amount X interest rate = Interest per year.

 

Interest per year ÷ 12 months = Interest per month

 

Interest per month ÷ # days in a month = % per day

 

% per day X # of days in the month after the closing date = $$ due at closing.

 

EXAMPLE:

$100,000 x 10% = $10,000 per year

$10,000 ÷ 12 = $833.33 per month

$833.33 ÷ 30 = $27.78 per day

Day of Closing?

1st of the month = owe a full month's interest due = $833.33

15th of the month = 15 days X $27.78 = $416.70

30th of the month = 1 day X $27.78 = $27.78

Looks like if you close later in the month your costs are less. Well . . sorta kinda.

 

If you close at the end of the month it is true that you won't have to pay as much interest, but it is also true your first payment would be due 30 days earlier than if you closed at the first of the month.

If you close at the first of the month you get to skip a payment and your first payment isn't due for 60 days. So when do you want your first payment to come due and/or do you have enough money in the bank to pay the 30 days worth of interest?

If you calculate total dollars paid out of pocket for that first year you will find it is actually cheaper to close at the first of the month and get to skip a payment.

 

There is another issue you have to deal with if you close at the end of the month. So many people have focused so intently on the reduced interest figure that most closings happen on the last day of the month. That means everyone is swamped!

There are over 30 people involved in your loan - surveyor, abstracter, title company closer, attorneys drawing the docs, etc. etc. So if any ONE of them is so busy they can't do their work in a timely manner your closing gets pushed back a day (to the 1st) and suddenly your interest figures go from $27 to $833. This makes it tough to plan plus you are back to being surprised at your closing cost figures.

Now if you were to schedule your closing for the 1st (or soon thereafter) no one is busy and if for any reason the closing has to be delayed a day or two the interest costs go DOWN $27 a day. Which scenario would make you happier?

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INSURANCE: You are required to insure your property for at least the loan amount. Federal loan statutes say your deductible cannot exceed $1,000 or 1% of the value whichever is greater. You do not have to insure the land, because it isn't going anywhere.

The mortgage company wants to insure (pun intended) that if your house should burn down or be swept away by a tornado they will be covered. From a mortgage company standpoint there is nothing worse than having a $100,000 loan on a bare lot worth only $20,000.

The downside to this is that because you must insure the property for the loan amount, on a 95% or a 97% loan you will actually be over-insuring your property because the lot is worth more than your 3-5% downpayment. Of course you won't get any arguments from your insurance agent on that account.

By the way there are no benefits to over-insuring a property other than paying too much. If the house were to burn, the insurance company would not give you the over-insured value, only the cost to rebuild. How can you find the cost to rebuild? That's easy, it's on the top of the second page of your appraisal.

When we get close to closing we'll help you shop for insurance. Remember it is the insurance agent's job to sell you as much insurance as they can. We'll tell you how to buy it for as little as you can.

 

Quick Insurance class: Agents will usually tell you insurance rates are set by the state, but that's only partly true. The state sets the ceiling on the rates which simply means an insurance company can't charge you more than a certain price, but they can charge less if they want to.

To keep you off balance agents also use a specialized vocabulary. It is like a test, if you don't know the lingo then they know you don't know how the system works.

You might be asked if you want substandard insurance and of course you answer NO. But substandard simply means it is priced below the state standard or top price. Your answer should be a resounding YES! I want substandard pricing.

When shopping ask how much the company DEVIATES from the state rates. I see 25% - 35% DEVIATION regularly which could amount to several hundred dollars a year discount. But if you ask them how much their rates are discounted they know you are not aware of how things work and will fall back on the line that the State sets the rates.

Shop multiple offices of the same company because rates can vary from office to office. Each office determines their profit margin. The State Farm office near our house is much more expensive than the office 5 miles away.

Make sure you are comparing apples to apples when you are shopping rates. The easiest way to ensure you don't get sidetracked and confused is to get a full quote from the first insurance company and then get quotes from other companies for that exact same coverage. Don't let different agents talk you into different coverage levels.

Listen and learn. When they try to sell you on extra coverage you might decide that you really do want extra coverage, just don't include it in your price comparisons. Once you find the agent and company you want to deal with you can always modify your coverage.

Who pays the most for insurance? We have found it is usually the person who has been with the agent for the longest. Keep in mind we see rates from many different companies so we can make educated comparisons. It seems that agents start out giving you a large deviation from state rates to get the business, but over the years you hear "the rates went up"which means they have gradually reduced the amount of deviation you received until you are now paying an UNDEVIATED top dollar. To protect yourself you need to shop rates every 2-3 years.

 

Most people buy HomeOwners (HO) insurance but you are only required to have Fire and Extended Coverage (Fire & EC).
Fire & EC covers the structure, but not the contents which, when you think about it, is all a mortgage company cares about since that is all that is included in the loan. Fire & EC is substantially cheaper than HO which reduces your closing costs and your monthly payments. If you bought Fire & EC you would probably also buy a Renters policy separately. Renters Policy is another example of the specialized Lingo. It sounds like it is only for Renters only when it fact it is simply CONTENTS coverage.

As I understand it Allstate, when they were under the escalator in the Sears stores, was the first company to bundle Fire & EC and Contents coverage together to come up with a HO policy. You originally got a discount if you bought the complete package. Now HO has become the standard and because no one ever shops differently, the original "discount" has disappeared and HO is usually more expensive than buying 2 separate policies.

Agents will very adamantly, tell you that it is more expensive to buy separate policies and that you can't do it. But once you price it I think you will find they are usually wrong. Of course this means you will have to deal with 2 different insurance agents because you can't buy both policies separately thru the same company. I learned this trick from an Insurance agent friend who always bought two policies and never bought a HO policy.

There are a couple of advantages to buying insurance separately, not the least of which is a smaller deductible. Deductibles on HO policy are usually 1% of the value ($100,000 home = $1,000 deductible). Deductibles on Contents is usually in the $250-$500 range. You also have more coverage on things like the hot water heater bursting and flooding the house.

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TAXES: You will owe property taxes from the day of closing until the end of the year. The Seller will owe taxes from January 1 until the day of closing.

Taxes are a tax write off for you now. they have been a tax write off for your landlord all these years.

Taxes for the current year are normally not even assessed on your property until October and then are due in January for the previous year. There is a discount if you pay the taxes early.

On a new property, unless it was completed by January 1, you are probably only being assessed at the much lower unimproved value. On many mortgage types you will have the choice of calculating your house payments based upon the unimproved value OR figuring payments based upon the anticipated full tax rate. There is a downside to both methods.

If you opt to use the lower unimproved value your monthly payments will be lower but you will have to pray the taxing authorities do not reassess your value any earlier than October because the large jump in value could cause you to have to come up with a large sum of money to pay the extra taxes right at Christmas time.

If you choose to go with the higher figure your payments will be higher and if they don't reassess your value until October you will end up with a large overage in your escrow account. You can either elect to have the extra money returned to you OR you can use it apply towards next year's payments OR it can be applied directly towards principle and reduce your loan balance.

Whether this choice is offered to you is a function of the loan type.

 

ESCROW ACCOUNT: Way back when, FHA started a revolutionary type of payment, it was called a Budget payment. They reasoned that it would be easier for people to pay a little bit each month than large lump sums periodically. Almost all loans made today are Budget payments. They allow you to pay a little bit of your taxes and insurance each month rather than the full lump sum when due.

This means that in most cases the title company will be setting up a new escrow account to collect these partial tax and insurance payments. The title company will collect a few months taxes and insurance payments in advance (to cover the period of time you aren't making any payments plus they will put into escrow the Seller's portion that he is paying at closing) so there will be enough money available to pay them when they come due.

The way the title company collects these escrow accounts at the closing can be a little confusing so let me try to explain the rationale behind their collection method.

 

INSURANCE: Insurance companies require their money upfront because they know you would not pay if you did not have a claim. This means you will pay for full year's insurance policy at closing AND you will also pay a few months worth of insurance to cover the period that you are not making payments. Escrow accounts are not paid in arrears, they are paid in advance. So you will definitely pay for two months insurance. In most cases they will also collect another month "just in case" rates go up. They want to be sure they don't have to come to you and ask for more money.

TAXES: Taxes are entered on your closing statement (HUD1) in a very bookkeeper fashion. For instance, if you were closing in July the title company would charge you for 10 months of taxes on your breakdown of costs and then give you credit for the Seller's 7 months on a different page. Unfortunately you will see the charge for 10 months a long time before you see the 7 month credit so it scares you.

INTEREST: Interest will be collected from the day of closing until the first of the following month.

 

Want to pay your own taxes and insurance? If you are putting at least 20% down it is possible to "waive your escrow account". This privilege will usually cost you $250 or .25%. The charge is to help offset the higher risk factors. What if you don't pay your insurance on time and the house burned? What if you don't pay your taxes? Tax liens take precedence over mortgage liens.

This added risk factor is why they also want you to have 20% of your own money invested before they will allow you to make these payments yourself. They want you to have as big an incentive to pay things in a timely fashion as they do.

They do not make money on your escrow account. Escrow funds must be put in a non-interest bearing account and cannot be used by the mortgage company in any way. It is illegal for them to use your money.