Prepaid Finance Charge

What Is a Prepaid Finance Charge?

A prepaid finance charge is an upfront cost associated with a loan agreement or credit extension and must be paid in addition to standard loan repayment. These expenses may include fees, commissions, or administrative costs and are not part of the borrowed amount and are prepaid by the borrower at closing.

Because prepaid finance charges are paid before the start of the repayment of the loan, these charges are not subject to any interest.

Understanding Prepaid Finance Charges

Prepaid finance charges are costs that borrowers must consider before they agree to a loan. These are consumer costs in addition to the interest, principal, and other charges incurred during the life of a loan. Because they are paid before the loan is advanced and when the transaction is closed, these costs are often referred to as closing costs.

The Truth in Lending Act (TILA) of 1968 stipulates that lenders must fully disclose the nature and amount of any prepaid finance charges before asking consumers to sign a contract. This is a federal law implemented by the Federal Reserve Board's Regulation Z, which protects consumers from unscrupulous creditors. Lenders that don't comply with the law may face fines.

Lenders charge various types of prepaid finance charges which may include administration fees, underwriting fees, origination fees, loan insurance, and program fees. Some fees, known as junk fees, may be excessively high and are often inflated fees, so consumers need to research and understand what costs are incurred.

Many borrowers use friction cost analysis to understand the total costs of a loan including its prepaid finance charges. The friction cost represents the total amount of fees associated with a loan including direct and indirect charges. Borrowers can use this method to do cross-comparisons between lenders.

Financial institutions may also waive or lower their fees after a negotiation initiated by the customer as lenders often use premiums or discounts to attract clients.

What Are Examples of Prepaid Finance Charges?

There are many different types of prepaid finance charges that lenders require borrowers to pay in advance or at closing. They may include:

• Origination fee: These are charges that a borrower pays when a new loan is processed. They usually range between 0.5% to 1% of the full value of the loan.
• Underwriting fee: This is a cost imposed by the lender to evaluate loan applications. In some cases, the lender may charge an underwriting fee over the origination fee, as is the case with some mortgages.
• Document fee: Also referred to as a doc fee, this is commonly used for car loans. Dealers and lenders charge this fee to prepare and process the loan paperwork.

The Bottom Line

A prepaid finance charge is a cost associated with a loan agreement or credit extension and is usually paid at closing before the start of the loan payment period. Expenses may include fees, commissions, or administrative costs. The Truth in Lending Act (TILA) requires lenders to disclose the nature and amount of any prepaid finance charges.