Pre-paids and Reserves? What are these and what is the difference?

If you’ve ever purchased or refinanced a home then it would be safe to assume that you may have been surprised….ok, SHOCKED, at the total amount of ‘closing costs’.  I bookended the term ‘closing costs’ with quotes because this term is both misused (by mortgage companies) and misinterpreted (by would-be homebuyers and refinancers as well as real estate professionals).

Closing Costs – Misquoted!

Lenders will oftentimes misquote ‘closing costs’ giving you ONLY the lender’s closing costs (such as processing, underwriting, credit report, etc).  This can VERY easily set you up for major frustration and sticker shock upon closing day.  How? Simple – the lender’s closing costs makes up only one portion of the total cash due at closing.  For a very detailed, yet concise, explanation of cash-to-close and the other costs involved click here!

Closing Costs – Misinterpreted!

It seems as though we’ve been conditioned to ask mortgage lenders a seemingly simple question.  “What are your closing costs?”.  Although this seems like a simple question, the answer is….er um…excuse me…. I mean, the TRUTH, is a little more complex, requiring one to be the equivalent of a mortgage loan officer veteran to crack the code.  If you were to ask a mortgage loan officer what their closing costs are they’d most likely tell you just that – THEIR closing costs.  Seems honest, right?  Yes and no.  Most often the information you really want and need to know is the amount of cash you’ll need to bring to closing (for a home purchase) or the amount of money being rolled into the new loan (for refinancing).  Therefore, a better question to ask would be “What do you anticipate my total estimated cash-to-close to be?”.  Framing your question up this way tells the mortgage loan officer that you’re asking for closing costs (theirs and other 3^rd parties), down payment, AND pre-paids and reserves.

Pre-paids and Reserves

Your total cash-to-close is comprised of three components

1. Down Payment
2. Closing Costs (Lender’s AND third parties)
3. Pre-paids AND Reserves

The down payment is self-explanatory and we covered closing costs in a previous article – find it here!

What are Pre-Paids & Reserves?

Simply stated, these are your property taxes, home owner’s insurance, and per diem (daily) interest collected at closing.   For example, in most cases lenders will collect 15 months of home owner’s insurance, 3-5 months of property taxes, and interest from the day your loan closes and funds through the end of the month.  Let’s dissect this:

1. Home Owner’s Insurance – one full year of home owner’s insurance is collected at closing.  The annual premium is sent to your insurance company, covering one year in advance – thus the term ‘pre-paid’.
2. Home Owner’s Insurance – in addition to the 12 months mentioned above lenders will collect another 3 months to jump-start your escrow account.  Why 3 more months??  Image this – you’re going to go 30 – 60 days before your first payment is made (depending on what time of the month you close on your home loan).  If the lender just began collecting insurance in your first payment then the lender would always be a couple of months shy when the bill comes due next year.
3. Property Taxes – lenders will collect property taxes from January 1 through the month and day you close on your home loan + 3 more months.  For example, if you closed on your home loan on June 15^th then the lender would collect taxes from January 1 through June 15^th (from the seller) and additional 3 months from you to jump-start your escrow account.  Same concept from above applies here – if the lender just began collecting your property taxes in your first payment then they’d always be a couple of months shy when the property tax bill comes due.
4. Per Diem Interest – lenders will collect daily interest from the day you close through the end of the month.  For example, if you closed on your home loan on June 15^th the lender would collect daily interest from June 15^th through June 30^th (16 days).

As you can see the pre-paids and reserves can certainly add up quickly thus significantly increasing your cash-to-close…..especially if your lender has not prepared you!

Be prepared!  Use this article to ask the right questions!  I’m curious, what’s the most frustrating part of the home loan process for you?  I’d love to hear your answer – email me here cole@coleholmes.com – Thank you!

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