What is the Prepaid Interest Charged on a Mortgage?

What is Prepaid Interest?

Prepaid interest is the interest that a debtor pays before the first scheduled debt repayment. For a more in-depth explanation of prepaid interest, Investopedia offers a great definition

For taxation reasons, many kinds of prepaid interest are expanded over the life of the loan. For mortgage loans specifically, prepaid interest can be the interim interest that accrues from the settlement date to the beginning of the first mortgage period. Prepaid interest is collected by the mortgage lender to pay for the interest charges for the rest of the month during which the loan closes escrow.

If you are seeking to minimize closing costs, consider closing later in the month to decrease the prepaid interest collected at the closing. Mortgage interests are paid in arrears after they are earned by the lenders. For example, the interest portion of the July mortgage payment pays for the interest accrued from June 1 to June 30. Prepaid interest is interest paid on the day of settlement, before being earned by the bank.

Always remember to be smart and don’t make these five mistakes when shopping for a home loan refinance – especially when concerning prepaid interest.

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How Prepaid Interest is Determined

The timing of the closing of a mortgage affects the amount of prepaid interest that is due, as well as how much time there will be before the first mortgage payment is required. Planning for the prepaid interest to be paid earlier in the month might give the borrower more time to then pay their initial mortgage payment.

Prepaid interest is still an upfront cost to cover. Setting the prepaid interest due date closer to the end of the month would allow the borrower more time to pay that cost. The initial mortgage payment will then be needed in short order. Changing the interest rate or the principal amount of the mortgage can reduce the prepaid interest that is due. However, a borrower may find it challenging to negotiate such changes with the lender.

It is possible for the prepaid interest that is due to change between the time of the loan estimate and the time of the closing disclosure. The charges may be prorated daily from the closing till the first mortgage payment comes due. That calculation will be based on the annual interest rate that will be applied to the mortgage. The specific calculation may vary by lender. There may be options to skip payments on the mortgage, but the prepaid interest will still need to be covered.

Where To Find Your Prepaid Costs On Your Loan

When you first get your mortgage loan document, it might be difficult to locate a description of your prepaid costs. Typically, prepaid costs are broken out on page two of your loan estimate, often labeled as “other costs” after the outlined closing costs. Once you locate this section, you should be able to identify the prepaid costs described in your loan.

Which Prepaid Costs Will Be Included In The Mortgage?

As you prepare to review your loan estimate and mortgage disclosure documents, it’s important to know what expenses to look for. Typically, the most common prepaid costs that are included in the mortgage are the homeowners insurance premium, real estate property taxes, mortgage interest and the initial escrow deposit.

Prepaid Insurance And Taxes

Prepaid insurance and taxes are two common prepaid costs included in the mortgage. Typically, 6 months to 1 full year of homeowners insurance is collected and prepaid at closing. In addition to prepaid homeowners insurance, your mortgage lender will also collect property taxes from you.

It’s up to the lender to determine how much is going to be collected, but this prepaid amount will be deposited into an escrow account and act as a cushion for you to pay your future bills.

Prepaid Interest

Mortgage interest is another prepaid cost included in the mortgage. It’s collected as a prepaid expense so the lender can put it toward the first mortgage payment, so no matter which day of the month you close, the lender will have at least 30 days to enter your information in the system to issue your first statement.

However, depending on what time of the month you close, the amount of interest required may vary. For example, some homeowners might prefer to close at the end of the month so that there will be less interest accrued in advance before your first monthly mortgage payment.

Initial Escrow Payment At Closing

The initial escrow deposit is the final prepaid cost you should expect to be included in your mortgage. The initial escrow payment is the money deposited with the lender which will be used to pay future homeowners insurance and property taxes. Look at your lender’s requirements to determine the cost of your deposit and whether it is needed in the first place.

Similar to the prepaid insurance and tax expenses, this initial escrow deposit will act as an extra cushion in your escrow account. The initial escrow deposit goes above and beyond initial prepaids and it will also continue to be held in escrow even after the first payments begin as a security precaution. If you use escrow, your mortgage insurance will be a separate prepaid cost.

Prepaid Interest on a Mortgage Refinance

If you already own a property with a mortgage atta

If you already own a property with a mortgage attached, interest accrues daily throughout the month.

Assuming you decide to refinance that loan by taking out a replacement loan, interest will be due on both the old loan and the new loan at closing.

Similar to a home purchase loan, the interest will be calculated by taking the mortgage interest rate and how many days each lender holds your loan.

This will be broken up between old lender and new lender, with interest before your closing date going to your old lender, and prepaid interest from closing date to month-end going to your new lender.

So if you close on January 20th, you’d pay 20 days of interest to your old lender and 11 days of interest to your new lender.

This way the full month’s interest is squared away when you close, and you can start fresh with no interest due.

Then after a month’s time, enough interest will have accrued to make a full payment, which will be due on March 1st.

For the record, the payment due on January 1st would cover interest for the month of December.

In terms of how that interest is paid, you’d owe daily interest to the old lender based on the current principal balance and mortgage rate.

For example, if your loan payoff was $250,000 and your mortgage rate 3.5%, daily interest would be roughly $24. That’s about $480 for 20 days.

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On the new loan, you’d owe 11 days of interest based on the new loan amount and interest rate.

If we’re talking a rate and term refinance with a 3% interest rate, it’d be $20.55 a day for 11 days, or $226.

Together, you’d owe about $706 to both lenders for the month of January.

As you can see, interest is paid to both the old lender and the new lender at closing when it’s a mortgage refinance.

How to calculate prepaids

Recall that your prepaid expenses consist of:

  • Six to 12 months of homeowners insurance premiums, plus two months for escrow reserves
  • Two months of property taxes as set by your local government (for example, if your annual property tax bill is $12,000, you’d prepay $2,000 into an escrow account)
  • Any interest that accrues on the loan from the closing date through the end of the month.

Your prepaids are calculated on Page 2, Section F of the loan estimate document you received from your lender, alongside closing cost details.

Understanding Prepaid Interest

During the final phase of a mortgage loan processing (commonly referred to as the closing), the homebuyer will receive a detailed disclosure statement listing all the costs related to the property purchase. This list can include real estate taxes, loan fees, recording fees, title company costs, and other expenses. Among the expenses due at closing are prepaid interest charges, which refers to the daily interest that accrues on the mortgage from the closing date until the first monthly mortgage payment is due.

Depending on when escrow closes, the borrower’s first mortgage payment could be several weeks or more in the future. The prepaid interest due at closing is the mortgage interest the borrower owes the lender during this time period before the first mortgage payment. While prepaid interest can occur in other types of loan situations where the borrower pays interest in advance before it accrues, it’s commonly associated with mortgages.

Prepaid Interest Is Unlike Rent

Prepaid interest is sometimes confused with pro rata rent payments, but the two concepts don't bear much in common.

Rent is typically paid before a tenant moves into a home. It usually covers a single month, from the first calendar day through the last. Sometimes, if you move into a home during the last week of the month, a property manager might "prorate" the rent. If they do, they'll collect one month plus a "pro rata" portion for that additional week, but the concept remains the same as a standard rent payment.

Whether you're paying a pro rata amount or moving in on the first of the month, you are paying in full before moving in.

Prepaid Interest

Interest paid in advance is deductible only as it accrues. The one exception to this rule is for certain points paid by a cash-basis taxpayer to obtain financing for a loan used to purchase, reconstruct, or improve his or her principal residence.Copyright © 2008 H&R Block. All Rights Reserved. Reproduced with permission from H&R Block Glossary

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