Prepaid items are paid for by the borrower at the time of closing, even though the payments are not due until a point in the future. Pro-rated real estate taxes, homeowner’s and flood insurance, private mortgage insurance (PMI), and interim interest are among the most common prepaid items. Interim interest may change depending on the closing date and the jurisdiction.
Key to understanding prepaid items is the idea that interest on a mortgage is always paid in arrears after it has had a chance to accrue on the balance. This is why the first payment date on a mortgage typically is at least one month after the closing date.
Also referred to as per diem, or per day, interim interest is an adjustment of the interest from the closing date until regular principal and interest payments start accruing under the term of the loan. For example, a borrower closing at the beginning of the month would pay 30 days of interest. The cost in this example is equal to the interest on one month’s mortgage payment.
If the cost of the per diem interest is too much for the borrower to take to closing, an interest credit may be arranged for a closing early in the month. This means that the lender does not collect any per diem interest at closing, but simply moves the first payment date to the first day of the month following closing. The first payment would be the regular principal and interest payment less interest for the number of days into the month that the closing occurred.
Borrowers may question their need to put money into escrow after paying insurance premiums for a year. They should understand that all insurance requires that the premium be paid in advance. The regular monthly payment for principal and interest, taxes and insurance (PITI) is due in arrears. The insurance anniversary date is the closing date. Typically, a lender receives ten monthly PITI payments before the insurance anniversary or premium due date. The insurer will expect to receive the annual premium that is twelve times the monthly insurance portion of the payment. To make up for the tow month shortfall, the lender places two months; insurance into the escrow account so there will be enough money to pay the premium when it comes due.
With private mortgage insurance (PMI), the procedure is the same. When utilizing PMI under the traditional plan, an initial premium is paid at closing. The one-year renewal premium will come due after the borrower has made only ten regular PITI payments. So to offset the expected shortfall, the lender collects 2/12ths of the renewal premium at closing.
If the PMI is a monthly plan, there is no initial premium. However, the premiums must be remitted beginning at the date of closing. In this case the lender will collect two months of the premium to make up for the fact that the first regular PITI payment is not expected for 30-60 days.
Real Estate Tax Escrows
Often real estate taxes are paid in advance. When this is the case, the lender must collect enough in escrow with the expected PITI payments to pay the taxes when due.
Calculating Taxes Due If taxes are due within two months after settlement, the lender will collect for the six-month of twelve-month full tax bill. The borrower must repay the seller for any amounts already paid. For instance, if the seller has paid one-half year in advance and the tax bill is based upon an annual assessment, the borrower could pay up to fourteen months of real estate taxes at closing; six months to pay back the seller, six months to the jurisdiction and two months into escrow.
Borrowers may be entitled to any government reduction in tax assessments, such as owner occupancy homestead deductions, senior citizens deductions or deferments.
There may be an additional closing cost to take into consideration, as well, with new construction. Until the property was sold, new construction was assessed as “unimproved.” A jurisdiction may assess an improvement levy or tax to compensate for the inability to tax the property until the issuance of occupancy permit/certificate.
Seller Paid Closing Costs
A seller may pay closing costs on behalf of a buyer. This is call a contribution and is acceptable because the lender is assured that the borrower is making an equity contribution in the form of a down payment.
Seller contributions are called concessions. Concessions are limited by law, because they may artificially inflate a home’s sale price. For example, a seller trying to sell a house without a swimming pool may find a buyer who wants a swimming pool. The seller may agree to give the buyer $10,000 to pay for a swimming pool to be installed. In such a case, the house price is being inflated to pay for a swimming pool that does not yet exist.
The danger in an inflated sales price is that the financing is based on a certain amount of equity contribution, or down payment, as a personal investment from the buyer. The seller’s concession may erode the buyer’s equity contribution to the point where the loan balance is greater than the value of the house. As a result concessions may be allowed, but the underwriter/lender should make a downward adjustment to the loan amount to compensate for a lower equity contribution.
From the seller’s perspective a sales price of $100,000 in a transaction with no contribution may seem the same as a$103,000 sales price with a 3% contribution nets the seller. The distinction is one of the valuation. If the contribution is traditional in the marketplace, and if the inflated selling price is supported by other comparable sales, the lender has some certainty that the borrower’s equity contribution/down payment is bona fide.