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If you’ve ever purchased a mortgage or taken out other loans, you might already be familiar with prepaid interest charges – even if you don’t know it.
Let’s take a deep dive into what these charges are, how they impact your mortgage, and more.
What are Mortgage Prepaid Interest Charges?
Prepaid interest is what it sounds like: interest that you pay in advance. While it shows up on other loans, mortgage lenders commonly talk about prepaid interest as it relates to mortgages.
To give a quick illustration, let’s say that you’re renting a house. Every month, you make a rent payment that secures your right to stay in your home for the upcoming month.
So, when you make your payment on January 1, you’re prepaying your rent from January 1 to January 31.
But with mortgages, you usually pay interest in arrears – that is, after it accrues. To use the example above, when you make your mortgage payment on January 1, you’re covering the interest accrued between December 1 and December 31.
However, there’s one time you may prepay your mortgage interest rather than waiting for it to accrue: when you close on your mortgage.
This prepaid interest, or interim interest, covers any prorated interest set to accrue between your closing date until the end of the current month.
Typically, lenders build this interest into your mortgage closing costs. You can find exact details in the lender’s documents under the “prepaids” section alongside property taxes and homeowner’s insurance.
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Is Prepaid Interest the Same as Points?
Prorated interest isn’t the same as mortgage points. Many lenders require you to pay this interest upfront rather than bundling it into your first mortgage payment. That said, mortgage points – discount points – do count as a type of prepaid interest.
Essentially, these are optional fees you can pay to reduce your interest rate for the life of the loan.
Typically, you’ll pay 1% of the loan amount per point, which can reduce your rate anywhere from 0.125% to 0.25%.
And, like other types of prepaid interest, you can usually deduct points as interest paid come tax time.
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Calculating Prepaid Interest for a Mortgage
Lenders may calculate prepaid interest in different ways depending on your amortization schedule, which can lead to slight discrepancies compared to calculating the charges yourself.
But if you’re looking for a ballpark number of what to expect come closing, the following calculations will get you close.
And if you notice a big difference in your calculations versus the actual payment, never hesitate to ask your lender why!
To calculate the prepaid interest for a mortgage, you’ll need a few pieces of data:
- Your annual interest rate
- The initial loan balance
- The number of days between your closing date and the end of the month
Once you have these numbers, it’s a matter of following the equation below to get your answer:
- Divide your annual interest rate by 365 days to get your daily rate
- Multiply your daily rate by your loan amount and divide by 100% to get your daily interest payment
- Multiply your daily interest amount by the number of days between closing and your first billing cycle (often the end of the month) to get the prepaid interest charge
Mortgage Prepaid Interest Example
Say that you take out a mortgage of $100,000 at 3% APR. If you close the loan on the first day of June and your first mortgage cycle begins the first day of July, you’d calculate your prepaid interest as so:
- 3% mortgage rate / 365 days = 0.0082% daily rate
- (0.0082% daily rate x $100,000 loan) / 100% = $8.20 daily interest payment
- $8.20 daily payment x 30 days = $246 in prepaid interest charges
How to Reduce Mortgage Prepaid Interest
If you don’t fancy a sizeable prepaid interest payment bundled into your closing costs, you may be able to reduce your liability.
The easiest way is to schedule your closing later in the month, which decreases the number of days you’ll owe prepaid interest.
However, this method also means you’ll make your first mortgage payment right after covering closing costs.
If you have the savings or cash flow at hand, that shouldn’t be a problem! But if you’re unprepared, you risk making your first mortgage payment incompletely or late – which isn’t a great look.
You can also reduce prepaid mortgage interest by negotiating a lower interest rate or loan amount.
Unfortunately, both methods often prove more difficult than pushing your closing date back a couple of weeks.
Benefits of Mortgage Prepaid Interest
Reducing your prepaid interest may seem an attractive prospect – but making the payment can actually benefit both the buyer and the lender.
To start, prepaid interest is typically tax-deductible, which means you can write off that portion of your closing costs come tax time.
Note that you’ll have to meet a few requirements, such as buying a primary residence rather than a rental property.
Secondly, prepaying interest upfront can also lower your first monthly mortgage payment since you won’t have to cough up the prior month’s interest at the same time.
And, because you’re circumventing this higher one-time cost, you’ll be able to set more aside for other needs, such as closing costs, new appliances or furniture, or home repairs.
How Prepaid Interest Affects Your Mortgage Refinance
Another area that prepaid interest shows up is during a mortgage refinance.
Typically, during a refinance, your former bank charges up to 30 days of interest above the loan’s principal balance when the second bank issues your payoff amount. You’ll pay this amount forward and receive a reimbursement for the balance of the interest.
But if you close early in the month, you may receive an interest credit and pay no prepaid interest on your former loan.
On the other hand, closing later may mean you’re responsible for “prepaid” interest between the first of the month and your refinance closing date.
Bottom Line: What Is the Prepaid Interest Charged on a Mortgage?
Paying prepaid interest on your mortgage covers your interest obligation while also minimizing your first month’s bill.
While this can be an attractive prospect, it does mean you’ll pay higher closing costs, especially if you’ve bundled a few discount points into your loan.