As the name implies, prepaid interest is money owed to a bank or mortgage lender and paid before its due date. You must pay it before the due date for several reasons, but the main reason is that mortgages are paid after the due date.
Since interest must accrue over time before anyone pays it, mortgage payments are due after the end of the month. Unlike rent, which is paid before the month in which the home is occupied, this is different.
The reason for prepaid interest on the mortgage
The loan’s cost between the mortgage’s closing and the first payment is known as prorated interest. Each day from the closing date until the first mortgage payment is due; the lender will charge prorated interest based on the interest rate for the term of the loan.
The lender must legally disclose the prepaid interest on your mortgage before the closing date. The loan estimate and closing statement will show this amount.
It summarizes the details of the monthly mortgage payments and loan fees. The amount will be included in your overall loan and shown in a section called “prepayments.”
On the other hand, the total price of the prepaid interest depends on the interest rate and the total loan amount purchased. Although it is usually a lower cost when compared to prepayments.
Calculating prepaid interest
Prepaid interest is usually calculated based on the interest already accrued on your mortgage balance as of the first day. You will need to use your mortgage interest rate, the initial loan balance, and the number of days between the closing date and the end of the month if you want to double-check the calculations behind prepaid interest costs.
Let’s take an example of a $200,000 mortgage loan with an annual interest rate of 4%. Typically, if you pay off this mortgage ten days before the end of the month, you will determine prepaid interest as shown below:
- Calculate your daily rate by taking your annual interest rate and dividing by 365 (4% / 365 = 0.011%)
- To get the daily interest rate, multiply the daily rate by the amount of your mortgage loan: 0.011% x $200,000 = $21.92
- To calculate the anticipated interest rate, multiply the daily interest by the days between closing and payment: $21.92 x 10 days = $219.20
However, an average mortgage loan of $200,000 at today’s rates should be about $22 per day. The actual interest paid upfront will vary depending on the size of the loan and the rate included in the calculation.
The exact calculation process may also change depending on the lender chosen. The daily interest rate, for example, may be determined by the lender as a percentage of the interest payment due in the first month of your amortization schedule.
While there is not much difference between these two approaches, it may help to explain the small differences between the prepaid installment in your documentation and your calculation.
Can I reduce the interest?
Delaying the closing date until the end of the month is the simplest method to reduce the cost of prepaid interest. However, this move will also indicate that you must complete the first mortgage payment shortly after paying the closing costs.
The added stress of making these two large payments in a row may not be worth the $200 you’ll save in prepaid interest if you tend to have cash flow problems.
You can avoid this difficulty by making enough money saved to meet both the closing costs and the first month’s payment. It won’t matter when you decide to set your closing date if you begin the mortgage application process by fully accounting for both costs.
Doing so allows you to choose a later signing date in the month when the prepaid interest will cost you less. While it is technically possible to minimize prepayment costs by reducing the loan size or interest rate, neither of these items is as susceptible to negotiation as the mortgage closing date. In either case, you should seek advice on the best solution.
Writer and content creator interested in Entrepreneurship, Marketing, Jobs and landlord issues. I have a bachelor’s degree in Communication from the Andrés Bello Catholic University, VE, and I also studied at Chatham University, USA. In this blog I write and collect information of interest around agreements, property and mortgage.