What Is Prorated Interest and How Is It Calculated?
Understand the financial principle that adjusts interest for partial billing periods, ensuring you only pay for the exact days you've borrowed money.
Prorated interest is the amount of interest charged for a portion of a standard billing cycle. This method is used when a financial event, like the start of a new loan or the payoff of an existing one, does not align with the first or last day of the month. Prorating interest ensures a fair calculation for both parties. It prevents borrowers from paying a full month’s interest for only a few days of having the loan and ensures lenders are compensated for the exact number of days the funds were used.
The Calculation Method
To calculate prorated interest, first identify the loan’s outstanding principal balance and annual interest rate. For example, a loan with a $300,000 principal balance and a 6% annual interest rate has $18,000 in total annual interest. This annual interest is then divided by the number of days in a year to find the daily interest amount. Lenders use either 365 or 360 days for this calculation, a detail that should be in the loan documents, as the 360-day method results in a slightly higher daily charge.
The final step is to multiply this daily rate by the number of days in the prorated period. Using the same example, if the prorated period is 15 days, a lender using the 365-day method calculates a daily rate of $49.32, for a total of $739.80 in prorated interest. If the lender uses a 360-day year, the daily rate becomes $50.00, and the total prorated interest is $750.00. This method is common for simple interest loans where interest does not compound daily.
Common Scenarios for Prorated Interest
Prorated interest often appears at the beginning of new financial agreements, especially in real estate. When a home purchase closes, the borrower pays interest for the period between the closing date and the end of that month. This prepaid interest is an itemized charge on the closing disclosure form, covering the initial, partial month before the first full mortgage payment is due.
This practice is also common with other types of credit, such as auto and personal loans. If a loan is disbursed on a day other than the start of a billing cycle, the first payment may be adjusted to include prorated interest. For example, if a car loan was finalized on the 15th, the initial payment will cover a full month plus the 15 days of the prorated period.
Prorated Interest on Debt Payoffs
Prorated interest is also a factor when a loan is paid off before its scheduled maturity date. Because interest on a loan accrues daily, the final amount due must account for this accumulation up to the day the payment is processed. To get an accurate final payment amount, borrowers must request a “payoff quote” from their lender.
This document provides the total amount required to close the loan, including the principal balance plus any prorated interest calculated up to a specific expiration date. These quotes are time-sensitive, so if a payment is received after the quote expires, additional interest will have accrued. The borrower would then need to pay the remaining balance to officially close the account.