When buying or refinancing a home, borrowers often hear the terms closing costs, escrows and prepaid expenses used together. Although all three can affect the amount of money needed at settlement, they are not the same thing.
Understanding the difference can make your Loan Estimate and final closing figures much easier to understand.
What Are Closing Costs?
Closing costs are the actual fees and charges associated with obtaining the mortgage and completing the real estate transaction. These costs can vary depending on the loan program, lender, property, title company and location of the home.
Closing costs generally fall into several categories.
Lender and Mortgage-Related Fees
Depending on the lender and loan program, mortgage-related costs may include items such as:
- Appraisal fee
- Credit report fee
- Origination, underwriting or processing fees
- Tax service or flood certification fees
- Discount points, if you choose to pay points to obtain a particular interest rate
Not every lender structures its fees the same way, which is one reason it is important to compare the complete loan terms rather than focusing on a single fee.
Title and Settlement Fees
A purchase or refinance will generally include title and settlement-related charges. Depending on the transaction and jurisdiction, these may include:
- Settlement or closing fees
- Title search and related title charges
- Lender’s title insurance
- Owner’s title insurance, when purchased
- Recording or document-related charges
Title insurance costs and settlement charges can vary based on the property’s value, location and the title company being used.
Government and Recording Charges
Transfer taxes, recordation taxes and recording fees can represent a meaningful portion of the costs associated with a home purchase.
These charges vary considerably throughout Maryland, Washington, D.C. and Virginia. They may depend on the jurisdiction, purchase price, loan amount, property type and other factors. In some transactions, certain transfer-related charges may also be divided between the buyer and seller according to the sales contract or local custom.
Other Transaction Costs
Depending on the property and transaction, there may also be additional costs such as survey fees, condominium or homeowners association charges, inspections, attorney fees or other property-specific expenses.
What Is an Escrow Account?
An escrow account is an account maintained by your mortgage servicer to collect money for certain property-related bills that will become due in the future.
The most common escrowed expenses are:
- Property taxes
- Homeowners insurance
- Mortgage insurance, when applicable
Certain properties or jurisdictions may have additional charges that are collected through escrow.
A portion of these expenses is generally included with each monthly mortgage payment. The mortgage servicer holds the money in the escrow account and then pays the applicable bills when they become due.
Why Is Money Collected for Escrows at Closing?
When a new mortgage is established, the lender may need to collect money at closing to create an initial balance in the escrow account.
The amount depends on several factors, including when property taxes and insurance bills are due, when your first mortgage payment will be made and how much needs to be available in the account when those bills become payable.
This is why two buyers purchasing similarly priced homes can have different initial escrow requirements.
Can Your Escrow Payment Change?
Yes. Property taxes and homeowners insurance premiums can change over time. Mortgage servicers generally perform periodic escrow analyses to determine whether the amount being collected is sufficient to pay the anticipated bills.
If the account has a shortage, your monthly payment may increase or you may be given an option to pay some or all of the shortage. If the account has a sufficient surplus, you may receive a refund, subject to applicable servicing requirements.
What Are Prepaid Expenses?
Prepaid expenses are different from closing costs. They are generally expenses associated with owning the home or having the mortgage that are paid in advance at settlement.
Common prepaid expenses can include:
- Prepaid mortgage interest
- Homeowners insurance premiums
- Property taxes, depending on when they are due and the transaction
- Initial deposits into an escrow account
These amounts are sometimes grouped together with closing costs when discussing the total cash needed to close, but they are not all fees charged for obtaining the mortgage.
How Does Prepaid Mortgage Interest Work?
Mortgage interest is generally paid in arrears, meaning your regular monthly mortgage payment pays interest for the preceding month.
At closing, however, interest is typically collected from the date of settlement through the end of that month. This is commonly called prepaid interest or per diem interest.
For example, a borrower closing near the end of the month will generally have fewer days of prepaid interest due at settlement than a borrower closing near the beginning of the month.
Your first regular mortgage payment is generally due on the first day of the second month following the month in which you close. Your specific closing date will determine the exact timing.
Homeowners Insurance and Property Taxes
Homeowners insurance is typically established before closing, and depending on the transaction, an insurance premium may be collected at or before settlement. If your mortgage includes an escrow account, additional funds may also be collected to establish the initial insurance escrow balance.
Property-tax collections depend heavily on the property’s location, when taxes are due and how the taxes are handled between the buyer and seller at settlement.
This is particularly important in the Maryland, Washington, D.C. and Virginia markets because tax schedules and settlement practices vary by jurisdiction.
Closing Costs vs. Escrows vs. Prepaids
A simple way to think about the difference is:
- Closing costs are fees and charges associated with obtaining the mortgage and completing the transaction.
- Escrows are funds collected and held by the mortgage servicer to pay certain future property-related bills.
- Prepaid expenses are costs associated with the home or mortgage that are paid in advance at settlement.
All three can contribute to the amount of cash needed at closing, but understanding what each category represents makes it much easier to review your mortgage figures and compare financing options accurately.
Have Questions About Your Closing Costs?
Before closing on a home, I can help you review the estimated costs associated with your mortgage and explain where the money is going. If you are comparing loan options, it is also important to distinguish actual lender costs from escrows and prepaid expenses rather than simply comparing the total cash-to-close figure.
Questions?
Call or text me at 240-670-5090 or email me at CJMT@mainstreethl.com.
