What Are Seller and Buyer Prorations?
Many purchase contracts used in real estate contain provisions for prorations between sellers and buyers. Before signing a purchase contract, you should read it to find out how prorations are handled, because you might want to propose a change in the verbiage about them. In most cases, buyers are charged for prorations, and they show up as a debit on the buyer's closing statement and as a credit on the seller's closing statement. The credits increase the seller's net profits and reimburse the seller for items the seller has prepaid for the period the seller will not own the property.
Mortgage Interest Prorations
Unlike rent, which is paid in advance, mortgage interest is paid in arrears. When you pay a mortgage payment on January 1, for example, it pays the interest for December. On a new mortgage loan, lenders want to collect interest up to 30 days before the first mortgage payment is due, so if you close on, say, November 15, your first mortgage payment will be due January 1. As the borrower, you will be charged 15 days of interest on your closing statement, from November 15 to December 1. To figure out your interest proration in this scenario, use the following formula:
- Loan Amount * Interest Rate = Annual Interest
- Annual Interest / 12 Months = Monthly Interest
- Monthly Interest / 30 Days = Daily Interest
- Daily Interest * 15 Days (November 15 to December 1) = Interest Debit Proration
The same principle applies to sellers who must pay interest in conjunction with a loan payoff, according to the lender's beneficiary demand.
Real Property Tax Prorations
Every state bases its property tax calendar year differently. Your first step should be finding out how your county collects taxes. Some states collect property taxes in advance, some collect in arrears, and some collections depend on the time of year. Either way, they're usually paid in two installments. The next thing is to figure out if your closing period involves prepaid taxes. If the taxes are prepaid, and you are the seller, you will receive a credit. If the taxes are prepaid, and you are the buyer, you will be charged. The opposite is true if taxes are not yet due and payable—sellers will receive a debit proration and buyers a credit proration.
In some situations, even if the taxes are not yet due and payable, if your closing date is near the date the taxes will be due, your closer will pay the taxes from the seller's proceeds, credit the unused portion to the seller, and charge the buyer accordingly. Some calculating buyers will ask for no tax prorations in the purchase contract if it is apparent that the buyer will be expected to reimburse the seller for a portion of prepaid taxes. If you are a seller in this situation and don't understand the significance of no prorations, you will pay taxes for a period that you did not occupy the property.
Homeowner Association Dues Prorations
Since most homeowner associations collect monthly dues upfront (some HOAs bill quarterly or annually), if a seller has not yet paid the dues, they will be paid from the seller's proceeds, and the seller will receive a credit for the unused portion. For example, if the dues are $300 a month, the daily proration is $10. When a transaction closes on the 10th of the month, the seller will be charged 10 days of HOA dues ($100). The buyer will pay $200 for the remaining 20 days of HOA dues.
Rent is generally paid in advance. Buyers who purchase an investment property expect to receive a credit for that portion of the rent, which covers the period the buyer will own the property. A sale that closes on November 15, involving a tenant-occupied property that rents for $1,000 a month, would result in the buyer receiving credit for 15 days of prepaid rent ($500). The seller would receive a debit of $500. Security deposits held by the seller are also transferred to the buyer as a credit to the buyer and a debit to the seller.
Insurance premiums are paid in advance, and buyers typically take out a new hazard/fire insurance policy when buying a home. However, if the buyer is assuming the seller's existing loan or buying on a land contract, a buyer might ask the seller to transfer the existing insurance policy. Fire insurance policies generally transfer with or without consideration. With consideration means the seller will be reimbursed for the period they will not own the property, and without consideration means there will be no prorations. Most buyers obtain a new policy.
It is not often that utilities are prorated at closing, but prorations do apply to certain municipalities. In most cases, the utilities roll over to the tax assessments and are deducted from the tax bill for prorations. The buyer is then credited against future tax bills. You will see this situation happen in short sales and foreclosures because if the seller isn't making the mortgage payments, they are probably not paying the utility bills.