Prepaid interest charges on a mortgage loan represent the amount of interest that you owe between signing your loan agreement and making your first monthly payment. Also known as interim interest, prepaid interest is charged by lenders as part of the upfront closing costs in a mortgage.
- What Are Mortgage Prepaid Interest Charges?
- Calculating Prepaid Interest for a Mortgage
- How to Reduce Mortgage Prepaid Interest
What Are Mortgage Prepaid Interest Charges?
Prepaid or interim interest represents the cost of borrowing money over the period of time between your mortgage closing date and the date of your first payment. Most mortgage lenders will charge you prorated interest for each day from your closing date until the end of the current month, based on the rate agreed upon for your full term. You can find the exact cost of prepaid interest for your mortgage in the documents that lenders are legally required to provide prior to the closing date.
With the exception of reverse mortgages, all mortgage products include a Loan Estimate and Closing Disclosure that summarize the financial details of your monthly and upfront costs. Both forms include a section listing out the various "prepaids" you'll need to cover upfront: homeowner's insurance premiums, property taxes and prepaid interest. While the final cost of prepaid interest depends on your loan amount and mortgage rate, it generally makes up the smallest single item among your prepaid costs.
Calculating Prepaid Interest for a Mortgage
Prepaid interest is generally calculated using the first day of accrued interest on your mortgage balance. If you want to double-check the calculation behind your prepaid interest charges, you'll need to use your mortgage rate, initial loan balance and the number of days between your closing date and the end of the month. As an example, consider a $200,000 home loan with an annual interest rate of 4%. If you close this mortgage 10 days before the end of the month, you generally would calculate your prepaid interest like this:
- Take your annual interest rate and divide it by 365 to calculate your daily rate = 4% / 365 = 0.011%
- Multiply your daily rate by your home loan amount for your daily interest amount = 0.011% x $200,000 = $21.92
- Multiply the daily interest by the number of days between closing and payment to get the prepaid interest charge = $21.92 x 10 days = $219.20
Your own prepaid interest will obviously vary depending on the loan amount and rate that go into your calculation, but a median mortgage loan of $200,000 at current rates should come out to roughly $22 per day. The precise method of calculation may also vary according to the lender you choose. For instance, a lender might also set the daily cost of interest as a fraction of the interest payment due in the first month of your amortization schedule. While the actual difference between these methods is small, it may explain slight discrepancies between the prepaid charge listed in your documents and what you calculate for yourself.
How to Reduce Mortgage Prepaid Interest
The most direct way to minimize the cost of prepaid interest is to delay your closing date until the end of the month, but this also means you'll need to make your first monthly mortgage payment not long after you've paid your closing costs. If you have issues with regular cash flow, the added strain of meeting these two large payments back-to-back may not be worth the couple hundred you'll save on prepaid interest. You can avoid this dilemma by making sure that you have enough saved up to cover both your closing costs as well as the first month of payment.
If you go into your mortgage process with both sets of expenses fully accounted for, then it won't matter when you decide to set your closing date. This will leave you free to aim for a signing date much later in the month, when prepaid interest will cost you the least amount. While it's also technically possible to reduce your prepaid charges by lowering your loan amount or interest rate, neither of these factors are as easily negotiable as the closing date of the mortgage.