Prepaid Interest

Prepaid interest is the sum you pay up-front on a loan, typically a mortgage. It’s used to cover the time between your loan closing date and your first monthly payment date. Normally, when you close on a mortgage, your first payment is due within the first few days of the following month. However, in that case, the interest starts accruing immediately. To account for this, lenders require you to pay the prepay the interest that accrues from the closing date until the last day of the month. By paying this interest upfront, your first regular payment aligns with the beginning of the next full month, making your payment schedule more straightforward.

Calculating Prepaid Interest

To estimate your prepaid interest, you’ll need to know the following.

• The total amount you’re borrowing;
• The mortgage annual percentage rate (APR);
• The exact day you close on your mortgage;
• How many days until the end of the month after the closing date.

The formula for calculating prepaid interest is:

(Loan amount x Interest rate)/365 x number of days between funding and end of month

How to Manage Prepaid Interest

To avoid paying more prepaid interest than you would like to, remember a few things.

• Since prepaid interest is due at closing, include it in your closing costs budget. This ensures you’re prepared for the additional expense and avoids last-minute financial stress.
• If possible, choose a closing date that minimizes your prepaid interest. Closing towards the end of the month reduces the number of days you’ll need to prepay interest, lowering your upfront costs.
• Get a Loan Estimate form from your lender. It includes an itemized list of closing costs, including prepaid interest. Review this document carefully to understand how much you’ll owe and ensure it fits within your budget.
• Set aside extra funds for closing costs, including prepaid interest. By saving ahead of time, you can comfortably cover these expenses and don’t let them interfere with your other important spending.
• Contact your lender to agree on the exact amount of prepaid interest due at closing. Ask questions if you have any unanswered concerns.

How to Lower Prepaid Interest

If you want to further reduce your upfront mortgage costs, you could also do a bit of legwork. Here are a few common tactics.

• The lending market is vast and diverse, so choose carefully. Don’t pick the first choice on the list. Compare multiple lenders, you might find one with more favorable terms, including lower prepaid interest requirements.
• Choose a shorter loan term. Instead of a common 30-year one, pick 20 or 15. Those options often come with a lower interest rate. We should add that it may increase your monthly payments, so don’t do it if your budget isn’t suited for this option.
• Having a higher credit score makes you more trustworthy, so lenders may offer you a lower interest rate. This way, you’ll have less prepaid interest at closing.
• Put down a larger down payment. This will get you better loan terms and lower interest rates, which can, in turn, reduce your prepaid interest.

Understand and plan for prepaid interest. By managing this aspect of your mortgage more effectively, you will be able to smoothly close it and make sure your finances don’t take a lasting hit.