What Is Prepaid Expenses?

Prepaid expenses are specific charges home buyers must pay at closing, including prepaid interest, property taxes, and insurance premiums.

A Longer Definition: Prepaid Expenses

Prepaid expenses are upfront fees that home buyers pay at closing linked to costs that aren’t yet due. They’re charged per diem from the closing date through the last day of the month and paid to mortgage, insurance, and title companies.

Prepaid costs vary based on closing date, property location, mortgage terms, and local tax rates. The most common prepaid expenses paid by home buyers at closing are prepaid interest, property taxes, and homeowners insurance.

Prepaid Interest

Prepaid interest is the interest due on a mortgage from its closing date until the first monthly payment comes due. It’s the only time that a homeowner pays mortgage interest in advance. Every other month, mortgage interest is paid in arrears. Prepaid interest ensures that the interest for the first partial month of ownership is covered. Prepaid interest is why home buyers get to “skip a month” of mortgage payments when they first move in – the interest was already paid.

Property Taxes

Most mortgage programs require home buyers to pay from two to ten months’ worth of property taxes upfront at closing. The number of months withheld is prorated based on the closing date and when the local jurisdiction collects its real estate taxes. Property tax money is typically held in an escrow account managed by the lender, who then pays the taxes on behalf of the home buyer when taxes come due.

Homeowners Insurance

Mortgage lenders require homeowners to show proof of a 12-month homeowners insurance policy at closing to protect their investment in your property. Homeowners insurance pays for repairs if your home is damaged by storms or other causes. The policy must be paid in full before closing.

Prepaid Expenses: A Real World Example

Consider a first-time home buyer who closes on a property on April 15. At closing, the buyer will pay the interest on the mortgage – whether it’s an FHA loan, conventional loan, or other mortgage type – from the closing date through the end of April, plus a prorated share of the property taxes based on the closing date, and the first year’s homeowners insurance premium on the home. These prepaid costs are settled at closing, ensuring the buyer’s mortgage and property are adequately serviced.

Common Questions About Prepaid Expenses

Are prepaid expenses negotiable?

In general, prepaid expenses are not negotiable because they’re based on the closing date and other factors unrelated to the mortgage, including the home’s insurance premiums and property tax rate. A home buyer can reduce their prepaid expenses by moving their closing date closer to the end of the month.

Can prepaid expenses be rolled into the loan?

For a purchase transaction, prepaid expenses cannot be added to a loan. However, home buyers can negotiate for seller concessions to shift the cost of prepaid expenses to the home seller.

Do prepaid expenses vary by location?

Yes, prepaid expenses differ based on the property’s location, particularly with property taxes and insurance premiums.