How Are Mortgage Interest, Taxes, and Insurance Prorated?

Proration is the financial process of dividing property-related expenses between the buyer and seller at closing. This allocation ensures that each party is responsible for costs only for the specific days they legally own the property within a given billing cycle. This mechanism is a standard part of real estate transactions and is handled by a closing or escrow agent who calculates the final figures. These adjustments are itemized on the final settlement documents.

Expenses Subject to Proration at Closing

Several ongoing homeownership costs are subject to proration, as their payment cycles rarely align perfectly with the closing date. These shared expenses are calculated and reconciled to ensure both the buyer and seller pay their proportional share. The most common items include property taxes, mortgage interest, and homeowners association fees, each with its own method of calculation based on whether they are paid in advance or in arrears.

Property Taxes

Property tax proration depends on the local jurisdiction’s collection schedule and whether taxes are paid in arrears or in advance. When taxes are paid in arrears, the bill covers a period that has already passed. In this scenario, the seller has lived in the home without yet paying the taxes for their period of ownership and will give the buyer a credit at closing for those days.

Conversely, some jurisdictions require property taxes to be paid in advance. If a seller has prepaid taxes for a full six or twelve months and then sells the property partway through that period, the buyer must reimburse the seller for the portion of the tax period during which the buyer will own the home. This reimbursement appears as a credit to the seller.

Mortgage Interest

Mortgage interest is paid in arrears, meaning a payment made on the first of the month covers the interest that accrued during the previous month. A new loan’s first payment is often not due until the first day of the second month after closing. For example, if a closing occurs on May 15, the first full mortgage payment would not be due until July 1.

To account for the interest that accrues from the closing date through the end of that month, buyers are required to prepay this amount at closing. This is known as prepaid interest or per diem interest, and it ensures the July 1 payment correctly covers the interest for the entire month of June.

Homeowners Association or Condominium Fees

Homeowners Association (HOA) or condominium fees are collected in advance, typically on the first day of each month or quarter. This payment covers services for the upcoming period. When a property sale closes mid-month, the seller has usually already paid the fee for the entire month.

Therefore, the buyer is responsible for these fees from the closing day forward and will credit the seller at closing for the portion of the month they will own the home, reimbursing the seller for the prepaid dues.

Homeowners Insurance

Homeowners insurance is handled differently from other prorated items because the buyer must secure their own policy before closing. The seller’s insurance policy is not transferred to the buyer. Consequently, there is no proration of insurance costs between the buyer and seller on the closing documents.

The seller is responsible for canceling their own homeowners insurance policy after the sale is complete. Upon cancellation, the seller’s insurance provider will issue them a prorated refund for any unused premium.

Calculating Prorated Amounts

The calculation of prorated expenses is managed by the closing agent. It involves determining a daily rate for an expense and then multiplying that rate by the number of days each party is responsible. The formula begins with the total cost of the expense for its billing period, which is divided by the number of days in that period to establish the daily rate.

Two methods are used to determine the number of days: the 365-day method, which uses the actual number of days in the year, and the 360-day method, which assumes each month has 30 days.

For a property tax proration example, assume the annual taxes are $4,200 and the closing is on August 16. Using the 365-day method, the daily tax rate is $11.51 ($4,200 ÷ 365). If taxes are paid in arrears, the seller is responsible for the period from January 1 through August 15, which is 227 days. The seller’s share is $2,612.77, which will be credited to the buyer at closing.

In another example involving a monthly HOA fee of $250 paid in advance, imagine a closing on the 20th of a 30-day month. The daily fee is $8.33 ($250 ÷ 30). The buyer must reimburse the seller for the remaining 11 days of the month, resulting in a credit of $91.63 to the seller from the buyer.

Locating Prorations on the Closing Disclosure

All prorated amounts are formally documented on the Closing Disclosure, a standardized form provided to both buyer and seller at least three business days before closing. This document provides a detailed breakdown of all costs and credits, showing how they affect the final amount of money the buyer needs to bring to closing and the net proceeds the seller will receive.

These adjustments are typically found on page 3 in the “Summaries of Transactions” section. This section features two columns, one for the buyer’s transaction and one for the seller’s, detailing debits (costs) and credits (payments or amounts received).

For an expense paid in arrears, such as property taxes, the prorated amount will appear as a debit to the seller and a corresponding credit to the buyer. This shows the seller paying their share and the buyer receiving that amount to put toward the future tax bill.

Conversely, for an expense paid in advance, like HOA fees, the prorated amount is a debit to the buyer and a credit to the seller. Prepaid mortgage interest appears only on the buyer’s side of the ledger, listed as a debit under a section often titled “Prepaids.”