What it means
Mortgage interest is normally paid in arrears, meaning each monthly payment covers the interest for the previous month. If a loan closes in the middle of a month, there is a gap between the closing date and the start of the first full interest period.
The lender collects interest for those days at closing, and that amount is called prepaid interest. The reason is to line up the borrower's payments with a regular schedule.
By collecting interest to the end of the month at closing, the lender can set the first payment for the start of the month after next. A borrower who closes late in the month therefore pays little prepaid interest, while one who closes early pays more.
The amount is calculated on a daily basis. The lender divides the annual interest by a day count, such as 360 or 365 days depending on the loan terms, and multiplies the daily figure by the number of days.
This is sometimes called per diem interest, and it appears on the closing statement as one of the borrower's costs. Prepaid interest is not an extra fee, because it is genuine interest for days when the borrower has the money.
However, it is a cash cost at closing, so buyers should budget for it along with legal fees, taxes and other charges. Choosing a closing date near the end of the month can reduce it, although the saving is usually modest.
In accounting for a business, prepaid interest is interest paid before the period it covers. It is recorded as a prepaid expense, an asset, and released to the income statement as the period passes.
This keeps profit matched to the period in which the borrowing was actually used. It is worth asking the lender or closing agent for an itemised closing statement a few days before completion.
The statement shows the exact number of days charged, the daily rate used and the total, so you can check the arithmetic yourself. Mistakes are uncommon, but a quick review costs nothing and avoids surprises on the day.
In practice
Real-world examples.
Example
A family buys a house and closes on the 18th of a 30-day month. The lender charges 13 days of interest at $45 a day, which is $585, at closing. The first mortgage payment is then due at the start of the month after next.
Example
A buyer delays closing by a few days to the last day of the month. The prepaid interest falls from $480 to $40. She saves $440, although she weighs this against the cost of delaying the move. A later closing can also mean paying rent for longer, so the saving is not always real.
Example
A company pays $12,000 of interest in advance on a six-month loan and records it as a prepaid expense. Each month, $2,000 is moved from the balance sheet into the income statement. By the end of the loan, the asset is zero and the full $12,000 has been charged as expense. Spreading the cost in this way matches the interest to the months in which the money was actually borrowed.
Formula
Calculation
Prepaid interest = loan amount x annual rate / day count x number of days.
A borrower takes a $300,000 mortgage at 6% and closes with 12 days left in the month, using a 360-day year. Annual interest = $300,000 x 6% = $18,000. Daily interest = $18,000 / 360 = $50. Prepaid interest = $50 x 12 = $600. On a 365-day basis the daily figure would be $18,000 / 365 = $49.32, so the total would be about $592.Case study
Seen in the real world.
Willow Park Developments is a fictional property company used here for illustration. It completed a $2,400,000 loan on the 10th of a 30-day month at an interest rate of 7.5% and a 360-day year.
Daily interest was $2,400,000 x 7.5% / 360 = $500, and prepaid interest for 21 days came to $10,500. The finance manager had not included this in the closing budget and had to find the cash at short notice.
After the episode, the illustrative company added prepaid interest to its standard closing checklist. It also began scheduling closings near month end whenever possible. Across a year with eight closings, the change reduced prepaid interest by several thousand dollars.
Watch out
Common mistakes.
- Thinking prepaid interest is a lender's fee. It is real interest covering days when you hold the loan.
- Forgetting to budget for it. It is a cash cost at closing and varies with the date.
- Assuming the day count is always 365. Lenders may use 360 or 365 days, which changes the amount slightly.
Questions
People also ask.
Do I get prepaid interest back?
Generally no, because it pays for days the loan was outstanding, but check the closing statement for errors.
Why does the first mortgage payment seem so late?
Interest is paid in arrears, and prepaid interest covers the first partial month.
Is it tax deductible?
Rules vary by country and by purpose of the loan, so speak to a tax adviser.
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