Prepaid interest, as the name suggests, is money owed to a bank or mortgage lender that is paid before it is actually due.
There are a number of reasons why it must be paid in full before the due date, but the main one is that mortgages are paid in arrears.
Due to the fact that interest must accrue (over time) before it can be paid, mortgage payments are therefore due after the month has ended.
Unlike rent, which is paid ahead of the month you occupy a rental unit, this is different.
Prepaid interest is frequently listed as a line item with your other closing costs when purchasing a home or refinancing an existing mortgage. Let’s learn why.
Prepaid Interest on a Home Purchase
Although there is typically a grace period to pay until the 15th of the month, mortgages are typically due on the first of the month.
Furthermore, since mortgage lenders do not accept partial payments, each month’s payment must be made in full.
There’s a good chance that when you buy a house, you’ll close on an arbitrary day of the month, like the 10th, 15th, or 24th.
This means that during the first month, an odd number of days will have interest added to your mortgage.
You simply take care of it at closing rather than being asked to pay that unusual amount of interest as your first mortgage payment.
Take care of it by paying it in advance at a daily rate so that you can start over as soon as the loan funds.
Using one of our closing dates, those who close on the 10th would have a closing balance of 20–21 days’ worth of “per diem interest.” Per diem simply means per day. It is also known as interim interest.
In spite of the fact that the full mortgage payment is not yet due, this guarantees the lender will receive interest payments while you hold the loan and live in the home.
The prepaid interest, however, causes your first mortgage payment to be delayed by one month.
Keep in mind that before a payment is made, interest must have accrued for a full month.
The first mortgage payment wouldn’t be due until Match 1st if your home loan closed on January 10th, but you would pay 21 days of prepaid interest at closing.
Why? Since you already paid the interest that ordinarily would have been a part of your February 1st payment at closing.
You now have to wait until interest starts to accrue in February before paying that sum, along with a portion of the principal balance (the loan amount), in March.
Although it’s not really skipping a payment—rather, it’s deferring and paying just the interest portion—this is frequently referred to as “skipping a mortgage payment.”
Prepaid Interest on a Mortgage Refinance
If you currently have a mortgage on a property, interest is accumulated every day throughout the month.
Interest will be due on both the old loan and the new loan at closing if you choose to refinance that loan by taking out a replacement loan.
The interest will be calculated similarly to a home purchase loan by taking the mortgage interest rate and the number of days each lender has your loan.
The interest accrued prior to your closing date will be split between your old lender and your new lender, and the prepaid interest accrued from your closing date to month’s end will be paid to your new lender.
Therefore, if you close on January 20, you would pay your old lender 20 days’ interest and your new lender 11 days’ interest.
In this manner, the entire month’s interest is settled at closing, allowing you to start over with no interest owed.
The full payment will then be due on March 1st after a month has passed and enough interest has accumulated.
For the record, December’s interest would be paid with the payment due on January 1st.
Regarding how that interest is paid, based on the current principal balance and mortgage rate, you would owe daily interest to the previous lender.
If, for instance, your loan balance was $250 000 and your mortgage interest rate was 3. 5%, daily interest would be roughly $24. That’s about $480 for 20 days.
Based on the new loan’s new loan amount and interest rate, you would owe 11 days’ worth of interest.
It would be $20 for a rate and term refinance at a 3% interest rate. 55 a day for 11 days, or $226.
For the month of January, your combined debt to both lenders would be about $706.
As you can see, when a mortgage is refinanced, interest is paid to both the old lender and the new lender at closing.
How to Calculate Prepaid Interest
Although the escrow officer assigned to your loan should prevent you from having to calculate prepaid interest on your own, it’s still a good idea to understand how it works.
Additionally, you can verify their math to gain a better understanding of mortgage lending.
Let’s look at an example of prepaid Interest.
Loan amount: $200,000 Mortgage rate: 3% Daily interest: $16.44
To calculate the per diem interest amount, multiply the mortgage rate by 365 (days).
For example, if the mortgage rate is 3%, it’d be . 03%/365, or 0. 00008219.
After that, multiply that by the loan’s principal (let’s assume it’s $200,000) to obtain $16. 44. I rounded it up from $16. 438.
The total amount of prepaid interest due is calculated by multiplying that sum by the number of days for which per diem interest is due.
So it would cost $197 if you needed to pay it off over 12 days. 28, and that would be in addition to your other closing expenses, like your loan origination fee, a home appraisal, etc.
Advice: Prepaid interest isn’t a waste of money or an extra expense. Unless you close on the very last day of the month, it is largely unavoidable.
When Is the Best Time to Close Escrow?
In the end, whether it’s a refinance or a home purchase, you don’t always get to choose when you close, but there are some factors to take into account.
When buying a home, closing later in the month results in less prepaid interest being due. And perhaps your landlord will receive less wasted rent.
If you close on the 30th of the month, for instance, and the per diem interest is $50, you might pay $100.
Additionally, if your lease is renewed on the first of the month, you wouldn’t be required to pay another month’s rent.
On the other hand, if you close on the eighth day of the month, you might owe $1,150 in per-diem interest at closing. Higher closing costs result from this, which could put your loan approval at risk.
The catch is that it would take approximately seven weeks before your first mortgage payment was due, as opposed to four weeks for a mortgage that closes on the 30th.
Consequently, you have more time until the first payment is due, which is nice. Additionally, a lender credit that compensates for the prepaid interest may be obtained.
Nowadays, many transactions are set up as “no cost loans,” which means that the lender pays the closing costs through these credits rather than having the borrower pay them directly.
In order to cover these expenses, the home sellers might also offer seller concessions.
The disadvantage is that the interest you pay is essentially just additional interest and does not actually reduce the amount of your loan.
Be aware that lenders are frequently very busy, so there may be delays or errors if you close close to the end of the month.
Your lender might give you a “credit” for the interest days if you close very early in the month, like on the 4th, and they might set your first mortgage payment due less than 30 days later.
Your first payment is due the following month, which is a drawback, but on the plus side, you avoid paying any unnecessary interest.
Best Day to Close a Refinance
The same reasoning essentially applies when refinancing, even though you’ll be paying interest to both the old and new lenders.
To avoid paying the higher per diem rate of interest, those who are refinancing should move forward with the process as soon as possible.
You could argue that you should avoid the end of the month because lenders are so busy, and perhaps aim for the third week of the month to avoid interim interest.
That would still give you roughly five weeks before the new refinance loan’s first payment is due.
Additionally, as mentioned, a lender credit could cover the interest paid to both the old and new lender.
If you close early in the month, you might be able to skip two payments if you time it just right, but this is risky and not for the faint of heart.
Also take into account your right to rescission, which delays the closing of your loan by at least three days, if it applies.
If you sign documents on a Monday, the lender won’t be able to fund until Friday, and if the old loan isn’t paid off right away, there’s a good chance you’ll pay “double interest” through the weekend.
Even though it’s not a significant expense, you should ideally sign on a Wednesday or Thursday and fund on a Monday or Tuesday to avoid this.
Simply put, the later in the month you close, the earlier the first payment on the new loan will be due.
The fact that you are paying money up front for a lower mortgage rate over the course of your loan means that discount points, if you pay them at closing, are also regarded as prepaid interest.
FAQ
What is prepaid interest charged by a mortgage company called?
Mortgage points are a type of fee that mortgage lenders impose on their clients and are regarded as prepaid interest. The one-time fee, also known as discount points, enables borrowers to lower the total amount of interest they pay the lender over the course of the loan.
How is mortgage prepaid interest calculated?
Explaining prepaid interest To calculate your prepaid interest, divide it by 365 days by your annual interest rate. Next, multiply that figure by the amount of your mortgage loan.
What is an example of prepaid interest?
For instance, a mortgage payment made on April 1 covers the interest for March. Prepaid interest is when interest is paid in advance of it becoming due.
What is prepaid interest charged by a mortgage company Weegy?
Prepaid interest, as the name suggests, is money owed to a bank or mortgage lender that is paid before it is actually due.