What is Prepaid Interest Charged By a Mortgage Company?
March 29, 2021
5 MINUTE READ
You are probably already familiar with prepaid interest from your first home mortgage, but you probably don’t know how prepaid interest will impact your refinance. As you take this next step in the refinance process, you’ll want to make sure you know every detail about prepaid interest and the effect it can have on your refinance.
Let’s take a look at how it’s calculated, when it’s required, and how it will impact your refinance so that you will be fully prepared.
What Exactly is Prepaid Interest?
Prepaid interest is the interest that a debtor pays before the first scheduled debt repayment. For a more in-depth explanation of prepaid interest, Investopedia offers a great definition.
For taxation reasons, many kinds of prepaid interest are expanded over the life of the loan. For mortgage loans specifically, prepaid interest can be the interim interest that accrues from the settlement date to the beginning of the first mortgage period. Prepaid interest is collected by the mortgage lender to pay for the interest charges for the rest of the month during which the loan closes escrow.
If you are seeking to minimize closing costs, consider closing later in the month to decrease the prepaid interest collected at the closing. Mortgage interests are paid in arrears after they are earned by the lenders. For example, the interest portion of the July mortgage payment pays for the interest accrued from June 1 to June 30. Prepaid interest is interest paid on the day of settlement, before being earned by the bank.
Prepaid interest is calculated by multiplying the per day interest on the loan by all of the remaining days left in the month. A refinance transaction normally refunds 3 days past the closing date and a purchase transaction generally funds on the exact closing date.
Here’s an example:
Let’s say your purchase transaction closes on May 26, 2021 and funds the same day. The per-day interest charge on the loan is $26.00 and there are 5 days left in the month. So, $26.00 x 5 days = $130.00 of prepaid interest on the mortgage.
One question that many people have when signing loan documents for a refinance is the question of timing when it comes to prepaid interest and closing. Is it better to close earlier in the month or later on in the month? It most cases, the closing date makes no difference when it comes to prepaid interest.
Interest is paid on your existing loan through its payoff date and this interest is collected, or “prepaid,” on the new loan from the closing date through the end of that month. Most people think it is less expensive to close at the end of the month because they are only looking at the prepaid interest. For example, if you close on the 10th of the month, the settlement statement would show a total of 21 days of prepaid interest, but if you close on the 20th, there would only be 11 days of interest.
Although, if you are looking to sell your home at the same time, you have to remember to note the number of days of interest that will be added to the payoff balance of your current loan. Generally, the interest rate on your existing loan is higher than the interest rate on your new loan, so it would be more beneficial to close as quickly as possible.
Many people enjoy the idea of skipping a payment. While yes, you won’t be making a payment directly to your mortgage lender for one month, (or sometimes even 2 months), interest will still be collected on your previous loan until the payoff date and interest accrues on your new loan from the closing date onward. Skipping a payment simply does not get you out of paying interest.
An exception to this is if your current loan is FHA, because FHA does not prorate interest daily. Check out this article on Zillow to learn more about FHA loans. Your payoff balance will include the interest through the close of the month, therefore with FHA loans, it’s beneficial to close your refinance at the end of the month to avoid paying interest on both of your loans at the same exact time.
How Prepaid Interest Will Affect Your Refinance
During a refinance interest will also be charged by the former bank. Normally 30 days of interest is charged, above the principal balance of the loan, at the time the bank issues a payoff amount. This amount will need to be paid forward and you will receive a reimbursement that will be issued for the balance within 30 days.
If you choose to close early in the month, you can receive an interest credit and pay no pre paid interest for that month. Although, your payments will not skip a month and your first payment will be due on the first day of the next month.
Prepaid interest must be disclosed on the Good Faith Estimate along with the other closing expenses. The amount listed on the Good Faith Estimate will correspond with the estimated closing date noted. For a more detailed explanation of the Good Faith Estimate, check out this article by the Consumer Financial Protection Bureau.
The amount of prepaid interest that you’ll pay at closing will be determined in relation to the actual closing date. Even though you will pay prepaid interest at the time of the closing of your new loan, you’ll more than likely skip one month’s mortgage payment too.
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