If you’re in the process of buying or refinancing a home, you will most likely come across a line item on your loan estimate that says “prepaid interest”. Prepaid interest is the daily interest that accrues on your loan between the date you close and your first mortgage payment.
- Prepaid interest is the daily interest that accrues on your loan between the date you close on your mortgage and the date your first payment is due
- Your prepaid interest amount depends on your interest rate and loan amount
- This amount can be reduced if you delay your loan closing date until the end of the month
Why is Prepaid Interest Charged on a Mortgage?
The prepaid interest is the cost of borrowing money between your mortgage closing date and the date of your first payment. Lenders charge prorated interest for each day from your closing date until your first mortgage payment is due. This is based on the interest rate of your loan term. Lenders are legally required to disclose the amount of prepaid interest for your mortgage before your closing date.
This amount will be listed on your loan estimate and closing disclosure form. It will summarize the details of your monthly mortgage payments along with your loan costs. The amount will be listed under a section titled “prepaids” and will be grouped under your total loan.
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The final cost of your prepaid interest depends on your interest rate and loan amount. It is usually the smallest cost associated with your prepaids.
How to Calculate Prepaid Interest On a Mortgage
The prepaid interest is calculated from the first day of accrued interest on your mortgage amount. To The prepaid interest amount is calculated from the first day of accrued interest on your mortgage amount. To calculate the sum of your prepaid interest you will need the following information:
- Mortgage interest rate
- Your mortgage balance
- The number of days between your closing date and the end of the month
Consider the following example below.
You’re applying for a $300,000 mortgage with an interest rate of 3%. If you close this mortgage 15 days before the end of the month, your prepaid mortgage interest would be calculated as follows.
- First, you will take your annual interest rate of 3% and divide it by 365 to calculate your daily rate = 3%/365 = 0.0082%
- After you have your daily rate, multiply it by your loan amount to calculate your daily loan interest amount = 0.0082% x 300,000 = $24.65
- Next, you will need to multiply the number of days between your closing and first payment by your daily interest charge = $24.65 x 15 days = $369.86
It’s also worth noting that some lenders may charge you mortgage points. Mortgage points are also considered a type of prepaid interest. If there are mortgage points charged on your loan, they will be outlined in your loan estimate.
Check out our prepaid interest calculator below to verify your prepaid interest amount.
Prepaid Interest Calculator
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Can You Reduce Your Mortgage Prepaid Interest Amount?
Yes, you can!
A simple way to reduce the cost of prepaid interest is to delay or schedule your closing date for the end of the month. It’s worth noting that if you do this, your first mortgage payment will be due not long after you’ve closed your loan.
This isn’t a big deal but it’s good to be aware of how it works so you can adequately prepare to make your mortgage payment.
Who Pays Prepaid Costs at Closing?
Prepaid line items are paid by the borrower at closing. They can either be paid directly by the borrower or they can be looped into the total loan amount. This is if the borrower doesn’t want to come out of pocket at closing. Another important concept when it comes to your mortgage is understanding how basic points work.
Either way, the total cost is very small compared to other costs associated with obtaining a mortgage. An added benefit is that you can deduct prepaid interest from your taxes at the end of the year.
Educating yourself on mortgage costs is important because lenders often make mistakes. Most will fail to properly educate you on how these costs work into the loan. As such, it’s important to understand the costs if you’re in the process of purchasing or refinancing a home.