Prepaid Finance Charge

What Is a Prepaid Finance Charge?

The term prepaid finance charge refers to an upfront cost associated with a loan agreement and must be paid in addition to standard loan payments. These expenses are not part of the asking amount and are considered to be prepaid in nature. These expenses are generally paid by the borrower when a loan is closed. Prepaid finance charges can include such things as administration fees, origination fees, and loan insurance.

Understanding Prepaid Finance Charges

Prepaid finance charges are important factors that borrowers must consider before they take out a loan. These are costs that consumers pay to a lender over and above interest, principal, and other charges. This means these costs are paid separately — usually before a transaction is closed. These costs effectively add to the costs of a loan since they must be paid upfront and in full before the loan is advanced. As such, these charges may also be 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 and shady creditors. Lenders that don't comply with the law may face fines.

The Truth in Lending Act requires lenders to be transparent about and disclose all fees associated with a loan.

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. Some fees, known as junk fees, may be excessively high, so it's important for consumers to be vigilant about each charge and how much they're expected to pay.

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 and choose the best one.

Special Considerations

There may be instances where financial institutions waive or lower their fees. This may require some degree of negotiation on the part of the borrower. Lenders often use premiums or discounts to attract clients. 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. Consumers should be sure to shop around for the best rates and cheapest fees. Those who have an established — and good — relationship with their lender may be able to score a waiver because of their loyalty.

Types of Prepaid Lending Charges

As noted above, there are many different types of prepaid finance charges that lenders require borrowers to pay. Here are some of the most common: