Everything You Need to Know About Prepaid Interest on Home Loans

Taking out a home loan is a major financial commitment. As you go through the mortgage process, you’ll encounter many fees and closing costs. One charge you may see listed is prepaid interest. What exactly does this mean?

In this comprehensive guide we’ll explain what prepaid interest is how it works with home loans, and why you pay it. By understanding this upfront mortgage cost, you can properly budget and prepare for your loan closing.

What Is Prepaid Interest on a Home Loan?

Prepaid interest refers to the daily mortgage interest a homebuyer pays at closing for the time between the loan closing date and the first mortgage payment

For example, if you close on May 15 but your first payment isn’t due until July 1, you’ll owe interest for those 45 days in between. The prepaid interest fee covers this interim period when interest accrues but payments haven’t started yet.

This one-time charge is due at closing and may range from a few hundred to a few thousand dollars depending on your loan amount, interest rate, and timing. It ensures the lender receives interest for the full period you’re borrowing money, not just once payments begin.

Why Do You Have to Pay Prepaid Interest?

When you close on a mortgage, the lender begins charging interest that same day. But they don’t receive the first payment for 30 to 60 days. Prepaid interest bridges this gap.

The lender earns interest on your loan starting at day one. Without prepaid interest, they’d miss out on up to two months of earnings. This fee ensures lenders don’t lose money during the time leading up to your first payment.

You pay interest in advance rather than waiting until the first mortgage bill comes due. This prevents falling behind or owing a higher first payment. Prepaid interest simplifies the process by keeping interest paid in alignment with accruals.

How Is Prepaid Interest Calculated?

The amount of prepaid interest due depends on your:

• Loan amount
• Interest rate
• Exact closing and first payment dates

The lender determines interest per day by taking the:

• Loan amount
• Multiplying it by the interest rate
• Dividing by 365 days

For example:

• $300,000 loan
• 5% interest rate
• 300,000 x 0.05 = 15,000
• 15,000 / 365 = $41.10 per day

If you close May 15 and first payment is July 1, that’s 47 days.

47 days x $41.10 daily interest = $1,931.70 prepaid interest fee.

This ensures the lender receives uninterrupted interest for the full term you have the mortgage.

When Do You Pay Prepaid Interest on a Home Loan?

Prepaid interest is due at closing when you purchase the home. The lender provides an estimated fee on the Loan Estimate form you receive when first applying.

This helps you budget and prepare for closing costs. The final amount due appears on your Closing Disclosure shortly before closing.

At closing, the prepaid interest fee is paid from your loan proceeds. The lender deducts it from the total mortgage amount disbursed to the title company handling settlement.

After the first mortgage payment, prepaid interest is no longer owed since the regular payment schedule takes over.

How Does Prepaid Interest Affect Your Monthly Payment?

Prepaid interest doesn’t directly change your scheduled mortgage payment amount. But it does increase your total closing costs.

Higher upfront costs mean you may need to finance more into your loan balance. This raises the principal borrowed and can increase monthly payments slightly.

However, the prepaid interest itself gets expensed at closing and doesn’t carry over. It does not extend the loan repayment term or repayment amounts.

Can You Pay More Prepaid Interest to Lower Your Rate?

Yes, you can voluntarily pay additional prepaid interest upfront through discount points. Points provide a rate discount, lowering your ongoing mortgage rate.

Each point equals 1% of the total loan amount. On a $300,000 loan, one point would cost $3,000. This prepaid interest can buy down the rate by 0.25 to 0.5%.

Discount points only make sense if the savings outweigh the upfront costs. Calculate how long it will take to break even on the lower rate before paying for points.

Are There Ways to Reduce or Avoid Prepaid Interest?

Unfortunately, prepaid interest is a standard closing cost you cannot opt out of. However, a few strategies may help lower the amount due:

• Shop for a lower rate: The lower your rate, the lower the daily interest owed.
• Time closing strategically: Closing later in the month gives fewer days until the first payment. This minimizes interest owed upfront.
• Make a half payment: Some lenders allow this to reduce prepaid interest, essentially making your first payment early.
• Request seller credit: Ask the seller to credit back part of the prepaid interest at closing.

While you can’t avoid this fee, shopping for the best rate and timing closing carefully can potentially help reduce the amount.

Prepaid Interest vs. Interest Due at Closing: What’s the Difference?

Closing Disclosures can list both prepaid interest and interest due at closing as separate charges. How do they differ?

Prepaid interest is the daily rate charged for the time between closing and first payment.

Interest due at closing covers the time from your loan application to closing date. Mortgage interest starts accruing once your loan is approved, even before the closing date.

For instance, if you apply May 1 and close May 15, interest due at closing covers May 1 to May 15. Prepaid interest is May 15 to July 1. The charges overlap for the 15 days between May 15 and May 31.

Is Prepaid Interest Tax Deductible?

Yes, prepaid interest and points paid at closing are tax deductible subject to IRS limits. You can deduct prepaid interest in the year it’s paid.

Mortgage interest is generally deductible for loans up to $750,000. Points are deductible up to the amount of interest paid during the year.

Work with your tax professional to determine the deductible amount if you pay significant prepaid interest or points. This can provide some savings to offset this closing cost.

Prepaid Interest: Final Thoughts

Prepaid interest is one of many closing costs homebuyers face when financing a home. While an unavoidable mortgage fee, understanding what it covers and how it’s calculated allows you to properly plan for it.

Paying interest upfront before payments start may feel burdensome. But it allows the lender to recoup interest starting at day one, rather than losing earnings until your first payment. This keeps the 30-year interest calculations simple.

While prepaid interest increases your closing costs, shopping for the lowest rate, timing your closing strategically, and utilizing tax deductions can help offset the burden. Being prepared for this charge will help you manage the cost.

Buying a home is a big investment filled with many new processes. While prepaid interest may sound complex, it’s simply a standard accounting practice to align interest accruals with payments. Planning ahead and budgeting for this cost will allow you to handle it smoothly as you transition into homeownership.