Types of Expenses Covered by Your Home Purchase Funds Requirement
At the closing of your home purchase, you will probably have to provide funds to cover four groups of expenses:
- Down payment
- Closing costs
- Prepaid expenses
- Reserve requirements
In fact, you may even have to prepay portions of the down payment and elements of the closing costs at the beginning of the home-buying process.
Down Payment
Your down payment is your initial equity position in the property. Lenders tend to view down payment in terms of risk exposure: the greater the down payment, the lower the risk for the lender — because the borrower has increased his or her stake in the property.
The type of property you purchase and specific loan program you select determines your minimum down payment. For example, single-family residential homes can be purchased with as little as 3.5% down payment with conventional and some conforming mortgage loans.
The typical homebuyer, however, normally provides a minimum of 5% down payment to purchase a single-family home.
With conforming loans, at least the first 3% (of the price) must come from the borrower’s own funds. The remaining portions of the down payment can be a gift from a relative. Some programs actually require that at least the first 5% (of the price) must come from the borrower’s own funds.
Closing Costs
The closing or settlement costs are additional, non-recurring expenses associated with the processing and closing of your loan and purchase transaction.
Closing costs are “non-recurring” or one-time fees, as opposed to prepaid expenses which are regular parts of your monthly payment.
The lender must provide each mortgage loan applicant with a Good Faith Estimate of closing costs and prepaid expenses at the time of application.
These costs include appraisal fees, title fees, attorney charges, local taxes and escrow account requirements. Generally, estimate closing costs of about 2% to 4% of your total purchase price, depending on the program selected.
Most conforming loans allow the non-recurring closing costs to be paid by seller subsidy, lender subsidy or a gift from a relative. However, such subsidies are usually limited to only 3% of the purchase price. Any closing costs above that level must be paid from the borrower’s own funds.
Prepaid Expenses
In addition to the standard closing costs, you will be responsible for certain prepaid expenses at the time of your home purchase closing.
Prepaid expenses are basically housing PITI (principal, interest, taxes & insurance) payments, which the lender requires in advance.
The most common prepaid expenses that homebuyers should expect include the following items:
- Prepaid interest
- Insurance premiums
- Escrow account requirement
Prepaid Interest
Most lenders set their due date to the beginning of each month. But what happens if your loan closes on a different day than the due date?
To cover the days from the closing date and the beginning of the next month, the buyer must prepay the daily interest — from the day of closing to the beginning of the next month.
This prepaid interest will reset your monthly payment to the beginning of the next month, which is what most lenders require to standardize their loan servicing.
There are some concepts to remember regarding mortgage payments and prepaid interest calculation:
- The mortgage lender will never give you a free day. You will be charged interest for every day you have that mortgage loan.
- Your mortgage is paid in arrears (unlike your rent). For example, your July 1 payment would assess the interest charges incurred for the preceding month of June.
- Most lenders set a uniform payment due date at the beginning of each month. Thus, if you close on any day other than the first of the month, the lender will reset for the beginning of the next month. The lender will charge you for that privilege, again because the lender never gives you a free day.
Here’s an example to clarify the prepaid interest charge:
- You close your purchase on April 20.
- The lender wishes to set a uniform due date for the 1st of each month. So, the lender resets the monthly due date to the beginning of the following month, May 1.
- The lender charges you daily interest for the 11 days to reset the loan to May 1.
- Your first payment will be June 1. [Remember that mortgage is paid in arrears: the June 1 payment is for the month of May; the 11 days of prepaid interest was essentially the May 1 payment for the shortened month of April.
If this is still complicated or confusing, don’t worry. Your attorney will explain it and protect your interest.
Just suffice it to say that the lender just wants to make sure that you never get any free days while you have a loan with it.
Interest Credit Exception
Note that there is an alternative to paying the prepaid interest. If you close at the beginning of the month, usually the first week, many lenders allow you to go with an interest credit option. In this situation, the lender will pay you, the borrower, the daily interest backwards from the closing date to the beginning of the current month.
The drawback is that your first mortgage payment will be at the beginning of the next immediate month — instead of “skipping” a month.
For example, let’s say you close on April 5. Instead of you paying 25+ days of prepaid interest, the lender will credit you with four days of daily interest, to the April 1 calculation. In effect, you are closing on April 1. Your first mortgage payment, however, will be May 1—not June 1, as in the previous example.
Insurance Premiums
The homebuyer must purchase a full year’s hazard insurance policy, and provide receipt and proof to the closing.
You do not pay this to the lender. Instead, you pay the insurance premium to your insurance provider — but it still must be paid in advance.
The reason for the insurance requirement is that your house is the security for your mortgage loan. The lender wants to ensure that if something happens to the property, the lender can still recover its loan principal balance.
If the property is in a designated flood zone, you must also purchase flood insurance coverage… in addition to the standard homeowners insurance policy. The typical homeowners insurance policy normally does not cover flood insurance, which is among the most expensive of insurance-covered damages to residential homes. In most municipalities today, local zoning and building departments place strong restrictions against building and development in flood-prone areas.
Escrow Requirement
The conforming loan borrower must establish an escrow, or impound, account with the new lender. At least two or three months worth of real estate tax and insurance (hazard, flood and mortgage) premiums are normally required to establish the escrow account.
The reason for this escrow is that the lender must ensure that when it must renew the insurance policy the following year or to pay the tax bills when they arrive, there will be sufficient funds in the escrow to do so.
This escrow requirement may be waived by qualified borrowers with the payment of an escrow waiver fee. Escrow waiver is an option for borrowers who make down payments of at least 25%.
Conforming loan programs require that the funds used for all of the prepaid expenses come from the borrower’s own funds. Many non-conforming lenders also require this. For more information about escrow accounts, please review the Escrow Accounts article.
Reserve Requirement
In addition to the above expenses, the borrowers must also provide evidence of sufficient reserves — over and above the required payments. Such reserve funds are required by all conforming loan programs, as well as many non-conforming loans.
The borrower will not have to turn over these reserves to the lender. These reserves will stay with the borrower and can be used without limits after the closing.
For the typical homebuyer, a two-month housing payment reserve is normally required. This means that the buyer must show sufficient funds to cover all closing costs, down payment, prepaid expenses — and still have enough documented funds left over to meet the reserve requirements.
With home purchases, these reserves may come from a gift. However, please note that total gift funds are limited by certain programs.
For reserve purposes, the monthly housing payment includes the projected monthly mortgage payment, insurance premiums, real estate taxes and other assessments. Two- to three-unit properties normally require three months of reserves, while investor (non-owner-occupied) properties will require at least five months of reserves.
