Escrows & Prepaids at Closing — What You Should Know

If you are buying a home or refinancing a mortgage, you should be aware of the two most potentially expensive components of your closing costs: Escrows and Prepaids.

What Are Escrows and Prepaids?

Escrows are the initial amount you must put aside (i.e., pay) at closing to fund your escrow account with sufficient funds so that your lender or servicer will have enough money in the escrow account to pay taxes and insurance when they are due (after the closing date).

Prepaids are the amounts you must pay prior to closing for insurance premiums and/or taxes that are due at or prior to closing.

How Do I Know How Much I’ll Have to Pay?

Within 3 days of your submitting a loan application, your lender will issue you a Loan Estimate (which used to be called a Good Faith Estimate) of all your closing costs, including escrows and prepaids.

Where Are Escrows and Prepaids on the Loan Estimate?

Look at Section F (Prepaids) and Section G (Escrows paid at closing). Your Closing Disclosure (formerly HUD-1) will also show prepaids and escrows in sections F and G.

Related Reading: Closing Disclosure Explainer

Are Escrows and Prepaids the Same with a Purchase or Refinance?

No. First let’s look at a refinance example. You are refinancing your existing loan. Your taxes are $3,600 a year, and your homeowner’s insurance is $600 a year.

In Florida, taxes are due once a year, and there is a discount if taxes are paid by November 1, so your lender or servicer will assume you want to pay your taxes by that date.

You close on your loan on July 15.  Your first mortgage payment would be due on September 1. Mortgages are paid in arrears. Your September 1 payment covers the interest for the month of August. That payment will include: principal, interest, taxes and insurance.

When you close on your loan, your servicer can only count on receiving two payments before the November 1 deadline: September 1 and October 1.  Therefore, from their standpoint, they will only have two tax payments in their escrow account but they will be required to pay out twelve months to the municipality.  So at closing, they will escrow (or ask you to pay) ten months worth of property taxes so that they have enough to pay a full twelve months when they are due.

Same with homeowner’s (or “hazard”) insurance.  Your insurance premium is $600 per year, but the annual premium is due January 1. When you close on July 15, the first payment is due September 1. On January 1, when your insurance company expects a check for $600, your servicer will only have four months (September, October, November, December) in their escrow account, so they will ask you for eight months at closing.

What Happens with Escrows and Prepaids on a Purchase?

The tax escrow calculation is the same. Your lender will escrow for enough money at closing so that they can pay the full tax that is due. With insurance however, on a purchase, you will be asked to prepay an entire full year of insurance premium before you can close. Why? Because your lender does not want to risk having your house burn down right after closing and you haven’t paid your insurance.

With insurance on a purchase, you not only have to prepay a full year, but you also have to escrow (i.e., pay) anywhere from one to two month’s worth of insurance payments at closing for a cushion.

What Is a Cushion?

A cushion is basically what it sounds like – extra money you have to lay aside so your servicer has something extra in case you don’t make your mortgage payments and they still have to pay property taxes and homeowner’s insurance.

How Much Is a Cushion?

It depends on your servicer and the state your property is located in. This chart shows you what your servicer can take as a cushion based on the state your property is located in.

What Else Is Different on a Purchase?

When you are buying a home, your seller (the owner of the home) has been making his/her own escrow payments every month to their lender or servicer. Therefore, at closing, depending on when taxes are due, they might have already prepaid taxes for a period of time after the closing date.

How Do You Settle up with the Seller for Taxes?

On your Closing Disclosure, Section K is called “Adjustments for items Paid by Seller in Advance of Closing”. This section deals with any adjustments that need to be made for payments made by the seller for taxes.

With a Refinance, How Do I Get Money Back from My Old Lender?

If you have an escrow account currently with your mortgage and you decide to refinance, you would be tempted to ask your new lender if you could just transfer the escrow funds to your new lender (instead of having to lay out money at closing to fund your new escrow account).

Unfortunately, this is not an option, because of the timing aspect of refinancing. First, when you close on a refinance loan of a primary residence, you must wait for a rescission period of three days (including Saturdays; excluding Federal holidays). So if you close on July 15, your loan would not fund until the fourth day (July 20, 2020). Funding means the new lender receives the loan proceeds. At that point, they will issue a bank check or wire to your payoff bank. Your payoff bank will then conduct an escrow analysis to see if there is any overage or shortfall in the escrow account. They are not set up to do a simultaneous exchange of escrow funds with your new lender.

Is There a Rule of Thumb for How Much Prepaids and Escrows Can Cost?

Yes. On a purchase, count on one year of insurance plus two month’s cushion. For taxes, if they are due twice a year, the worst case is six months. If they are due quarterly, the worst case is three months.

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