What is a Prepaid Finance Charge
A prepaid finance charge is an upfront charge associated with a loan agreement that is required in addition to the standard payments on a loan. Prepaid finance charges can include such things as administration fees, origination fees, and loan insurance. Since these expenses are not a part of the "asking amount," they are considered to be prepaid in nature. These expenses typically must be paid by the borrower at the time of loan closing.
BREAKING DOWN Prepaid Finance Charge
Prepaid finance charges add to the costs of a loan. They are an important consideration for borrowers and must be paid in addition to the loan’s specified interest.
Many borrowers use friction cost analysis to understand the total costs of a loan including its prepaid finance charges. Friction cost analysis can also be helpful in comparing loan options.
When a borrower is approved for a loan, the lender will provide a par rate of interest. The par rate of interest is the interest rate that the underwriter has calculated based on numerous factors included the loans reference rate, the lender’s risk parameters, and the borrower’s credit profile.
Loans can be structured in many different ways, also with different types of interest. Generally, a borrower will invest in either an amortizing or non-amortizing loan with fixed, variable or hybrid interest. The borrower receives the principal in a lump sum and must repay the principal with interest. Interest charges are typically the most significant cost a borrower will encounter with a loan. Interest payments are typically made monthly and included as a portion of a borrower’s total payment.
Prepaid Finance Charge Considerations
In addition to interest, many lenders will charge prepaid fees called prepaid finance charges. A borrower can assess the total costs of their loan including all interest and prepayment fees as well as indirect costs in a friction cost analysis.
Lenders can charge various types of prepaid finance charges so it is good for the borrower to compare across alternatives to save on fees. Prepaid finance charges may include administration fees, underwriting fees, origination fees, loan insurance, and program fees. (See also: Watch Out for "Junk" Mortgage Fees)
Some lenders may be willing to negotiate fees with the use of premiums or discounts. Premiums or discounts can be added to the borrower’s par rate to create an adjusted par rate negotiated with the lender. Adjusted par rates are often common in mortgage loans specifically.
To close a mortgage loan and various other types of loans obtained through a traditional lender, a borrower will be required to sign a closing statement and credit agreement. Lenders are required by regulations to draft certain documents based on the type of loan that the borrower is approved for. Generally, a borrower will receive a closing statement which includes all of the details of a loan agreement including the prepaid finance charges and interest costs. For standard loans, borrowers have three days to review the closing statement before signing the agreement. Reverse mortgages and refinancings will include a HUD-1 settlement statement which must be provided to the borrower within one day of closing. Closing statements are an important aspect of the lending process that provides borrowers with a detailed outline of all the finance charges they must pay to the lender for the loan.