What Is Prepaid Interest in Closing Cost?
Demystify prepaid interest. Understand this essential, often overlooked, financial detail within your mortgage closing costs.
When purchasing a home, buyers encounter various expenses beyond the down payment, collectively known as closing costs. These costs represent a collection of fees and charges associated with finalizing a mortgage loan and transferring property ownership. Among these numerous line items, prepaid interest often appears as a specific and sometimes confusing component.
Understanding Prepaid Interest
Prepaid interest refers to the portion of interest on a mortgage loan that is paid in advance at the time of closing. This payment specifically covers the interest that accrues from the loan’s closing date through the last day of that same month. It is essentially an upfront payment for the daily interest owed during this initial, partial month of the loan. This amount is distinct from other closing costs, such as loan origination or appraisal fees, which are charges for services rendered.
Unlike these other fees, prepaid interest is true interest expense, calculated on the loan principal for a short, defined period. It ensures the lender receives interest for every day the loan funds are utilized, preventing any gap in interest collection before the first full mortgage payment is due. The term “per diem interest” is sometimes used interchangeably with prepaid interest, emphasizing its daily calculation.
Why Prepaid Interest is Part of Closing Costs
Mortgage interest operates on an “in arrears” basis, meaning the interest due in any given month actually covers the principal’s usage from the previous month. For example, a mortgage payment due on October 1st covers the interest that accrued during September. This system creates a necessary “gap” period between the loan’s closing date and the start of the first full month covered by a regular mortgage payment.
Prepaid interest bridges this specific gap, ensuring continuous interest accrual and payment from the day the loan funds are disbursed. If a loan closes on any day other than the first of the month, interest will begin accruing immediately. Without a prepaid interest charge at closing, the lender would not collect interest for the period from the closing date until the end of that month, as the first regular payment would typically cover the next full month’s interest.
How Prepaid Interest is Calculated
Calculating prepaid interest involves a straightforward process based on the loan amount, interest rate, and the number of days left in the closing month. The first step determines the daily interest amount, often referred to as “per diem” interest. This is found by multiplying the loan’s principal balance by its annual interest rate, and then dividing that result by 365 days in a year.
Once the daily interest is established, this figure is then multiplied by the number of days remaining in the month of closing, including the closing day itself. For instance, if a $300,000 loan with a 5% annual interest rate closes on June 15th, the daily interest would be $300,000 multiplied by 0.05, divided by 365, which equals approximately $41.10 per day. Since there are 16 days remaining in June (June 15th through June 30th), the prepaid interest would be $41.10 multiplied by 16 days, totaling $657.60.