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 for costs that aren't yet due. These charges are calculated per diem from the closing date through the last day of the month and are paid to mortgage, insurance, and title companies.

Prepaid costs vary based on the closing date, property location, mortgage terms, and local tax rates. The most common prepaid expenses at closing include 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. It is 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. This is also why home buyers "skip a month" of mortgage payments when they first move in—the interest for that time was already prepaid.

Property Taxes

Most mortgage programs require home buyers to pay two to ten months' worth of property taxes upfront at closing. The exact number of months is prorated based on the closing date and the local jurisdiction's tax collection schedule. The property tax funds are usually held in an escrow account managed by the lender, who pays the taxes on behalf of the home buyer when they come due.

Homeowners Insurance

Mortgage lenders require home buyers to show proof of a 12-month homeowners insurance policy at closing to protect their investment in the property. Homeowners insurance covers repairs if the home is damaged by storms or other events. 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 type—from the closing date through the end of April. The buyer will also pay a prorated share of the property taxes based on the closing date and the first year's homeowners insurance premium. These prepaid costs are settled at closing to ensure the buyer's mortgage and property are adequately covered.

Common Questions About Prepaid Expenses

Are prepaid expenses negotiable?

In general, prepaid expenses are not negotiable because they are based on the closing date and other factors, such as insurance premiums and property tax rates. However, a home buyer can reduce their prepaid expenses by scheduling the closing date closer to the end of the month.

Can prepaid expenses be rolled into the loan?

Prepaid expenses cannot be added to a loan in a purchase transaction. 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 vary depending on the property's location, particularly when it comes to property taxes and insurance premiums.