Prepaid Interest

What Is Prepaid Interest?

Prepaid interest is the interest that a debtor pays before the first scheduled debt repayment. For taxation purposes, most kinds of prepaid interest are expensed over the life of the loan. For mortgage loans, prepaid interest can also be the interim interest that accrues from the settlement day to the beginning of the first mortgage period.

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.

Mortgage Points

Mortgage points, a kind of fee that mortgage lenders charge borrowers, are considered a type of prepaid interest. Also referred to as discount points, the one-time fee enables borrowers to reduce the amount of interest they pay the lender over the life of the loan. In general, the borrower will pay 1% of the total loan amount for each discount point. Each point reduces the interest rate on the mortgage by one-eighth to one one-quarter of a percent.

Similar to other types of prepaid interest, points are typically deducted over the life of the loan (in this case, a mortgage). Provided that certain conditions are met, the Internal Revenue Service (IRS) does allow this type of prepaid interest to be deducted in the year in which it is paid.

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.

Special Considerations

If a borrower seeks to refinance a mortgage, this could affect the prepaid interest on the new financing. The principal amount that remains due may be structured in such a way that allows the borrower to skip a payment. The borrower will still be responsible for the outstanding amount and will need to make prepaid interest on what is negotiated under the new terms of the financing they have procured.