When buying a home, you’ll encounter a variety of expenses that go beyond the purchase price of the property itself. Two key categories of these expenses are closing costs and pre-paids. While they’re both required to complete the transaction, they serve different purposes, and understanding the difference between the two is important to avoid any surprises at the closing table. Here’s a breakdown of what each term means and how they impact your homebuying budget.
What Are Closing Costs?
Closing costs refer to the fees and charges associated with finalizing a real estate transaction. These are one-time expenses that cover various administrative, legal, and processing tasks required to transfer ownership of the property from the seller to the buyer. Typically, closing costs are paid on the day of closing and include a wide range of fees, such as:
- Loan Origination Fees: The cost of processing your mortgage application.
- Appraisal Fee: A fee for the professional appraisal of the property to determine its value.
- Title Insurance: A policy that protects the buyer and lender against any issues with the title of the property.
- Attorney Fees: Legal fees for reviewing contracts and handling the closing process (in states where an attorney is required).
- Recording Fees: Charges for filing the deed with your local government to officially record the sale.
- Inspection Fees: Costs for home inspections, including general, pest, or other specialty inspections.
On average, closing costs can range from 2% to 5% of the home’s purchase price, depending on your lender, location, and the specifics of the transaction. It’s essential to factor these into your budget when planning for a home purchase.
What Are Pre-Paids?
Pre-paids are advance payments required for certain ongoing homeownership expenses that you’ll need to pay upfront at closing. Unlike closing costs, which are one-time fees, pre-paids cover future recurring costs such as insurance and property taxes. Lenders collect pre-paids to ensure that you have enough funds to cover these obligations in the early months of homeownership. Common pre-paids include:
- Homeowners Insurance: You typically need to prepay one year’s worth of homeowners insurance at closing to protect your new property from the start.
- Property Taxes: Depending on your closing date and local tax schedule, you may need to prepay several months of property taxes in advance.
- Mortgage Interest: If you close on a home partway through the month, you may be required to prepay the prorated interest for the remaining days of that month.
These pre-paid expenses are deposited into an escrow account, which your lender manages to ensure payments for taxes and insurance are made on time in the future.
Key Differences Between Closing Costs and Pre-Paids
The key difference between closing costs and pre-paids lies in their nature:
- Closing costs are one-time fees associated with the administrative and legal aspects of buying a home. They cover services needed to close the sale and transfer ownership of the property.
- Pre-paids are advance payments for future ongoing expenses, such as insurance, taxes, and interest. These costs are set aside in escrow to ensure those bills are paid when due.
In essence, closing costs are tied to the transaction itself, while pre-paids relate to future homeownership expenses.
Why Understanding the Difference Matters
Understanding the difference between closing costs and pre-paids can help you better estimate how much money you’ll need at the closing table. It’s common for buyers to focus on closing costs but forget to account for pre-paids, which can lead to unexpected expenses. Knowing both sets of costs ensures you’re fully prepared to cover everything when the big day arrives.
How to Prepare for Closing Costs and Pre-Paids
To avoid surprises, here are a few tips to help you prepare:
- Get a Loan Estimate: When you apply for a mortgage, your lender will provide you with a Loan Estimate, which breaks down the expected closing costs and pre-paids. Review this document carefully and ask your lender any questions you have.
- Budget for Both: Make sure to include both closing costs and pre-paids in your homebuying budget. Many buyers aim to save 3% to 6% of the home’s purchase price to cover these expenses.
- Negotiate with Sellers: In some cases, sellers may agree to cover part of the closing costs as part of the sale negotiation. This can help reduce your out-of-pocket expenses on closing day.