There's no doubt that mortgage settlement statements can be confusing to the layperson. There are no instructions to explain the forms, and the document bears little resemblance to the Good Faith Estimate.
For all of its line-item fields, though--and there are 143 of them(!)--the areas that tends to confuse homeowners the most are the ones collectively known as "prepaid items."
What are "prepaid items?"
"Prepaid items" are exactly what the name implies--payments made in advance of the monies being due.
With respect to mortgages, there are 10 types of prepaid items, the most common of which are:
- Mortgage interest that will accrue between the closing date and month-end
- Real estate taxes paid into an escrow account
- Homeowners' insurance paid into an escrow account
It's clear why the mortgage lender collects these items in advance at closing.
Mortgage interest is collected as a prepaid item so the lender can apply it to your first mortgage payment. This way, no matter which day of the month you close, the lender has at least 30 days to enter your data into its system, and issue your first statement.
This also gives the feeling of "skipping a payment" when, in reality, no such thing has happened. You've paid the first payment at closing, in advance of it actually coming due.
Taxes and insurance
Taxes and insurance, meanwhile, are collected to put into escrow. This is so your new lender can build your reserves and have enough to pay your bills when they come due.
Prepaid items are not closing costs. They are monies that would have been paid anyway--new home loan or not. Prepaid items are figures on your settlement statement unrelated to the process of getting a mortgage (with the single exception of upfront MIP for FHA mortgages).
Separating prepaid items from closing costs
On a settlement statement, prepaid items aren't called "prepaid items." They're categorized as "Items Required by Lender to be Paid in Advance" and "Reserves Deposited with Lender" and listed in Section 900 and Section 1000, respectively.
Note that neither of these settlement statement headings includes the word "charge," which would indicate a closing cost.
Note how closing costs are clearly labeled on other areas of a settlement statement:
- Line 801: Lender and broker's origination charge
- Section 1100: Title Charges
- Section 1200: Government Recording and Transfer Charges
Each of the above areas list costs assigned by lenders, title companies and governments. They are incurred because of the new mortgage.
For rate shoppers, this is an important distinction.
Better Good Faith Estimate comparisons
Knowing how to separate prepaid items from closing costs can help you shop for lower mortgage rates.
Prepaid items will be the same from lender-to-lender--they're separate from your mortgage terms. You can remove them from your cost comparisons.
Once you separate for closing costs, comparing for mortgage rates gets easy.
And if you're unsure about whether a certain item is a prepaid item or a closing cost, just ask yourself a simple question: "Is this a charge that I would have if I wasn't starting a new mortgage?"
If the answer is "yes," it's a prepaid item
Dan Green is a loan officer with Waterstone Mortgage in Cincinnati, Ohio, and the author of the nationally-recognized mortgage blog, TheMortgageReports.com. Dan speaks to national audiences about mortgage rates and the mortgage market. Follow him on Twitter at @mortgagereports.