What Is Prepaid Interest on a Mortgage?

Prepaid interest on a mortgage is a charge encountered during the home buying process, paid upfront at closing. It represents a portion of the interest due on a mortgage loan and ensures a smooth transition into the regular mortgage payment schedule. Understanding this charge is important for homebuyers.

Understanding Prepaid Mortgage Interest

Prepaid mortgage interest covers the period from the loan’s closing date until the end of the current month. This payment is necessary because mortgage interest is typically paid in arrears, covering the previous month’s use of funds. For example, a mortgage payment due on October 1st covers interest accrued during September.

When a loan closes, interest accrues immediately, but the first full mortgage payment is usually not due until the first day of the second month following closing. For instance, if a loan closes in August, the first full payment might be due October 1st, covering September’s interest. Prepaid interest ensures the lender is compensated for interest accrued during the partial month of closing.

Calculating and Paying Prepaid Interest

The amount of prepaid interest is calculated on a per diem, or daily, basis. Lenders determine the daily interest rate by taking the loan’s annual interest rate, multiplying it by the loan amount, and then dividing by 365 days. This daily interest amount is then multiplied by the number of days remaining in the month from the closing date, including the closing day itself.

For example, if a borrower closes on a $300,000 mortgage with a 6% annual interest rate on August 15th, the daily interest would be approximately $49.32 ($300,000 0.06 / 365). Since there are 17 days remaining in August (August 15th to August 31st), the prepaid interest would be $838.44 ($49.32 17 days). This amount is collected at closing as part of the overall closing costs. Borrowers will find this charge itemized on their Closing Disclosure document.

Financial and Tax Implications

Paying prepaid interest at closing covers only the initial, partial interest period and does not reduce the total interest paid over the life of the loan. It is not analogous to making an extra principal payment or reducing the loan’s overall interest burden. This payment ensures interest is accounted for from the moment loan funds until the regular payment cycle begins.

Prepaid interest is generally deductible as home mortgage interest in the year it is paid, provided the borrower itemizes deductions on their federal income tax return. This is consistent with the deductibility of regular mortgage interest, subject to certain IRS rules and limitations, such as the mortgage debt limit. Lenders report the total mortgage interest paid, including prepaid interest, to the borrower and the Internal Revenue Service (IRS) on Form 1098.

Prepaid interest differs from “points” (also known as discount points or origination points), which are also paid at closing. While points are considered a form of prepaid interest, their purpose is to reduce the interest rate over the loan’s entire term, unlike prepaid interest that covers a short, initial period. The tax treatment of points can vary; they may be deductible in full in the year paid under specific conditions for a primary residence purchase, or they may need to be deducted ratably over the life of the loan. This distinction is important for tax planning, as it affects a taxpayer’s financial position in the year of home purchase.