When real estate changes hands, the buyer and seller may have to pay a proportionate share of some expenses at closing. The expenses are prorated --that is, they're divided in a way that ensures each party pays, or is credited, his fair share. Commonly prorated expenses include property tax, homeowners insurance and mortgage interest.
Advance and Arrears Payments
Some prorated items, such as homeowners insurance, are paid in advance. They're referred to as prepaid items. When you prepay, the amount you pay today covers the cost of the product or service for the coming billing period. Alternatively, items such as mortgage interest are paid in arrears. With an arrears payment, the payment you make today covers the amount you owe for the previous billing period.
Items Commonly Prorated
Property tax is the most common prorated expense. However, a buyer who takes over the seller's homeowners insurance or mortgage usually pays a prorated premium or mortgage payment as well. In addition, most buyers owe mortgage interest at closing. Because the first mortgage payment is due the second month after closing, and mortgage interest is paid in arrears, buyers’ closing costs include the mortgage interest that accrues from the closing date to the date the first mortgage payment is due. Typically, a month’s worth of interest accrues between mortgage payments. However, when closing day falls after the usual mortgage due date, less than a month’s interest accrues for that shortened billing period. Therefore, the payment is prorated.
Credits to Buyer
Buyers prepay several expenses, including homeowners insurance and property tax. The prepayment amounts may range from a few months' worth to a full year of payments. The payments go into an escrow account. The mortgage lender draws from the escrow account to pay the bills on the buyer's behalf. On closing day, the buyer is considered to have prepaid these bills even though the mortgage lender hasn't yet made the payments. The buyer receives credit for any prepayments that cover the period the seller owned the home. If the buyer escrows a year’s worth of property tax payments, for example, and the seller hasn't yet paid the taxes, the buyer receives a credit for the seller's share of the tax. The credit reduces the buyer’s closing costs.
Credits to Seller
The seller receives credit for prepayments if the buyer will own the home during part of the time the seller's prepayment covers. A seller who pays the whole year's worth of property tax on Jan. 1, for example, is entitled to a credit for a sale that closes on July 1 because the buyer will own the home for half the year. The seller has, in essence, overpaid his share. The overpayment is reflected as a credit on the closing statement, and it increases the seller's net profit on the sale.
Charges at Closing
The buyer's closing costs include charges for prorated items the seller prepaid and will be credited for. These prorations are recorded on the closing statement as charges to the buyer. The charges increase the amount the buyer must pay to close the sale. The seller's charges are reimbursements to the buyer for the buyer’s credited prepayments. These charges reduce the seller's profit from the sale.
How to Prorate
Most real estate transactions use a 30-day month and 360-day year for prorations. The first step in determining how much each party owes is to take the total expense and divide it by 360 to find the daily rate. In the case of a $3,600 tax bill, for example, you divide $3,600 by 360 days. The daily rate is $10. Next, multiply the daily rate by the number of days each party owned or will own the home. For a July 1 closing, the buyer and seller each will have owned the home for 180 days. Multiplying 180 days by $10 per day shows that the buyer and seller each owe $1,800.
Daria Kelly Uhlig began writing professionally for websites in 2008. She is a licensed real-estate agent who specializes in resort real estate rentals in Ocean City, Md. Her real estate, business and finance articles have appeared on a number of sites, including Motley Fool, The Nest and more. Uhlig holds an associate degree in communications from Centenary College.