There is a lot of confusion about what comprises closing costs and prepaids and understandably so. I see a lot of posts on Bigger Pockets asking if I should refinance because my closing costs are XYZ. Often, these numbers sound incredibly high relative to the loan amount. But when you dig into the numbers a little deeper, you find that the borrower is lumping closing costs and prepaids
all together. In reality, these are two very different things, but they add up to what we call “cash to close”.
Let's define the difference between closing costs and prepaid items:
- Closing costs
are one-time fees that you will ONLY incur if you purchase or refinance a property. These can be further broken down into lender closing costs and third party closing costs.
- The
lender closing costs can include underwriting fee, processing fee, funding fee, origination fee, credit report fee, and tax service fee among others. You may also see a discount fee which means you are buying down your mortgage interest rate in exchange for higher upfront cost. Again, these fees are charged and paid to the lender to complete and fund the mortgage.
- Third party
closing costs include title company fees - including the actual title policy, escrow or closing fee, tax certification, and other title fees; governmental charges – including recording charges, intangible, and transfer taxes (depending on your state). Like the lender fees above, these would just be incurred if you refinance (or purchase.)
- Prepaid items
are the other part of cash to close total, (or what people colloquially call closing costs). These are very different than the fees outlined in the paragraph above. They are called “prepaid” for a reason because you were going to pay them whether you refinance or not. Prepaid items are comprised of property taxes and insurance and prepaid interest.
- Property taxes and homeowners’ insurance will depend on whether or not you have an escrow account, when you are closing, and when those items are due. If you close towards the end of the year you will have to pony up more taxes because most jurisdictions have the tax bills due at the end of the year. If you choose an escrow account on the new loan, you will need to fund the account to pay the full tax bill and insurance bill when they come due. The cost of insurance will depend on when your renewal date is. If you are refinancing within 60 days of your renewal date, you will likely have to pay the first year's premium at closing. Also, if you have anything in your existing escrow account, you will get that back within a few weeks of closing. This should be more or less the same as the amount that you are putting in.
- Prepaid interest is the interest (or mortgage payment) for the month you are closing. If your loan funds on the Nov 15th, the pre-paid interest will be from the 15th to the end of the month. Your next payment will not be due until Jan 1 as mortgages are paid in arrears, so the Jan 1 payment is paying the interest accrued in December. This will feel like you are skipping your December mortgage payment, but it will all be contained within your prepaid interest and your mortgage payoff.
Since insurance and property taxes are something you are going to pay whether you refinance or not. These are NOT closing costs.
It is very important to understand these differences in closing costs and prepaid costs when deciding if a refi makes sense or not. In high property tax, high insurance states like Texas, you may see $20,000 in cash to close while you are saving $250 a month to refi. Well, if it was $20k in closing costs
then it would make zero sense to refinance. But once you see that $16,000 of the $20,000 are prepaid homeowners’ insurance and property taxes (that you'll be writing a check for shortly anyway), you determine that the actual one-time closing cost is only $4000. Once you can determine the actual closing costs, you can quantify that the closing costs will be paid back in 16 months and the refinance now makes a lot of sense.
