Prepaid Expenses and Escrow Account Funding
Some fees are paid to the lender at closing in order to prepay interest and to begin building your escrow accounts, the accounts the lender uses to pay your property taxes and hazard insurance when the first bills come due after closing.
Interest is paid on mortgages in arrears. That means the interest included in each monthly mortgage payment covers the month prior to the payment. Your June payment pays the May interest. The May payment covers the interest due for April. If you are closing on a property October 18, your first payment will be due on December 1, and will include interest for the month of November, but not the days you owned the home in October. To make up for those days, your lender collects interest for October 18 through 31 at closing. The expense will be called
Each monthly loan payment you make will include approximately one-twelfth of the amount due annually for hazard insurance and property taxes. The lender accumulates the payments in a special account, called an escrow account, where the funds are held in trust until they are needed to pay your tax or insurance bill.
Lenders begin funding your escrow accounts at closing, usually charging you the equivalent of two to four months' payment for each expense. That way, your escrow account will be fully funded when the first payments come due the following year, and the account should contain excess funds to cover any increase in costs.
You've probably heard references to the term PITI during discussions about mortgages. The letters stand for “principal, interest, taxes, and insurance” — the components that make up your total monthly payment.
Don't confuse escrow funding with insurance and property taxes that are paid at closing. Those payments satisfy bills for the current year. Your escrow account accumulates funds for future payments, which your lender will mail for you to ensure they have been made, protecting their interests in the property.
If your taxes and insurance go up, so will your monthly escrow payments. The lender's goal is to collect enough money throughout the year so that payments can be made when bills become due without creating a negative balance in the escrow account.