What Is Prepaid Interest on a Mortgage?
When you buy a home or refinance a mortgage, you may see prepaid interest included in your closing costs. Despite the name, this isn’t an extra fee charged by the lender. It is simply mortgage interest that accrues between your closing date and the beginning of your first regular mortgage payment period.
Why Is Mortgage Interest Prepaid?
Mortgage interest is generally paid in arrears. In other words, each monthly mortgage payment pays the interest that accumulated during the previous month.
Suppose you close on a home on July 15. Your first regular mortgage payment might not be due until September 1.
That September 1 payment generally covers the interest that accrued during August. But what about the interest from July 15 through July 31?
That’s where prepaid interest comes in. At closing, you pay the interest that accrues between the closing date and the end of July.
The timeline looks roughly like this:
July 15: Close on the mortgage
July 15–31: Prepaid interest paid at closing
August: First full month of mortgage interest accrues
September 1: First regular mortgage payment
You aren’t really getting a “free month” without a mortgage payment. The timing of when the interest is collected is simply different.
How Is Prepaid Interest Calculated?
The lender generally calculates a daily interest amount and multiplies it by the number of applicable days.
For example, suppose you borrow $400,000 at 6%.
Annual interest would initially be approximately:
$400,000 × 6% = $24,000
That works out to roughly $65.75 per day using a 365-day calculation.
If 16 days of prepaid interest were required, that would be approximately:
$65.75 × 16 = $1,052
The actual calculation can vary based on the loan and lender.
Does Your Closing Date Matter?
Yes. Closing earlier in the month generally means more prepaid interest is due at closing, while closing toward the end of the month generally means less.
For example, closing on the 5th could require most of a month’s interest to be prepaid. Closing on the 28th might require only a few days.
However, this doesn’t necessarily mean that closing later saves you money in an economic sense. You are primarily changing when you begin owing interest. Once you borrow the money and own the home, interest starts accruing.