02/13/2024
Chances are if you are buying your first home, or even if you've bought before, you may be a little confused about the difference between Closing Costs, Escrows, and Prepaids.
While all of these are considered Settlement Charges (money that must be paid at closing), it can be confusing because some lenders will refer to all three categories as Closing Costs while others refer to them separately making it difficult to compare quotes between lenders.
Let's make it easy:
Closing Costs technically only include fees charged directly by the Lender (which may include origination, cost to buy down a rate, underwriting, admin, application or processing fees), cost of an appraisal, title fees and closing fees. Up front mortgage insurance on an FHA loan is also technically a Closing Cost, though traditionally lenders will refer to that fee separately from Closing Costs since that fee is determined by FHA, doesn't vary between lenders, and can be financed into the total loan amount.
Escrows are a portion of your total annual property tax and homeowner's insurance that the lender collects at closing to place into an account to ensure they have enough money to pay your next property tax and homeowner's insurance renewal when they become due. Most of the time, an escrow account is optional and you may be able to save yourself a significant amount at closing by opting out of escrows. If you do choose not to escrow your mortgage, you must be diligent enough to save 1/12 of the total annual amount of property taxes and insurance each month so you can pay the bill yourself when it becomes due.
Finally, Prepaids refer to amounts that must be paid in full at or prior to closing, but are not directly tied to the mortgage loan itself. For example, homebuyers must pay for a full year of homeowner's insurance up front. This is a Prepaid item. If you are doing a refinance and property taxes are due within the next 6 months, you may be required to pay that tax bill at closing, which would also be considered a Prepaid item. Because property taxes and homeowner's insurance are technically not related to the mortgage transaction but rather a cost of home ownership, these are not considered Closing Costs.
So, why does it matter what the difference is?
Most prospective mortgage applicants will ask the lender during the initial consultation, "what will my closing costs be"? If Lender A considers all three categories to be Closing Costs, they may respond with something along the lines of $6500 (this is merely an example as actual Settlement Charges are different for every transaction). If Lender B adheres to the strict definition of Closing Costs, they may respond with a significantly smaller total. For example, Lender B might state that Closing Costs are estimated at $3000. A customer who isn't aware that Lender B is not including Escrows and Prepaids in their quote may believe that Lender B's option is the best only to be surprised that their official Loan Estimate shows them paying far more than $6500 (Lender A's quote) at closing.
A reputable lender will verbally disclose ALL fees during the initial consultation regardless of whether or not they lump them together as Closing Costs or disclose them separately. Be sure to ask each lender if the amount they verbally disclose includes an estimate of Prepaid and Escrows.
A good rule of thumb is that Escrow and Prepaid items will be virtually the same regardless of which lender you plan to use as property taxes are determined by the County and the homeowner's insurance policy you buy is determined by you. The only way to truly compare lenders is to determine what the difference is between the actual lender fees on a given day at a given time.
