What is prepaid interest? It's actually pretty self-explanatory—it's interest paid in advance. You will most often hear this term used in association with a principal and interest payment (PI payment) for a mortgage.
Unlike rent for an apartment, which is paid in advance, mortgage interest is usually paid in arrears. That means it is paid after the amount accrues. A mortgage payment on April 1, for example, pays the interest for March. When interest is paid before it accrues, that payment is an example of prepaid interest.
- Prepaid interest occurs any time you pay interest on a loan in advance rather than in arrears, and it is common when closing a home loan.
- This usually covers the first few weeks of interest on a home loan—the period between when you close and when your first payment will begin to cover interest.
- Like other mortgage interest, prepaid interest is usually tax-deductible.
Common Instances of Prepaid Interest
Borrowers typically prepay interest when they take out a loan to either buy a home or to refinance an existing mortgage. As a borrower closes a deal, they prepay the interest that will accrue during their initial weeks in the home. Prepaid interest usually covers interest that accrues between the day the sale closed and the first day covered by the first mortgage payment.
For instance, a borrower may prepay interest up to the day that is 30 days away from their first mortgage payment. This means that if you close the transaction on March 15, your first mortgage payment will be due on May 1. Part of that May payment (the principal portion) will reduce the balance of the loan, while the other part pays off the interest that accrued throughout April. However, the May payment won't include the interest that accrued between March 15 and March 31, because that amount was paid at closing. That portion covering March interest, which was paid earlier, is the prepaid interest.
While this scenario deals only with principal and interest payments, it's important to remember that a real mortgage will include extra costs, taxes, and fees. To get a sense of the total cost of a mortgage, you must use the total monthly payment amount.
Prepaid Interest Is Unlike Rent
Prepaid interest is sometimes confused with pro rata rent payments, but the two concepts don't bear much in common.
Rent is typically paid before a tenant moves into a home. It usually covers a single month, from the first calendar day through the last. Sometimes, if you move into a home during the last week of the month, a property manager might "prorate" the rent. If they do, they'll collect one month plus a "pro rata" portion for that additional week, but the concept remains the same as a standard rent payment.
Whether you're paying a pro rata amount or moving in on the first of the month, you are paying in full before moving into the home.
Benefits of Prepaid Interest
It might seem like prepaid interest is just another way to tack on fees to closing costs, but the payer can enjoy a few benefits for making the payment.
For one, prepaid interest is usually a form of tax-deductible interest. That means, depending on the specifics of the home and your tax situation, you may be able to deduct the entire amount of the prepaid interest during tax season. There are specifications you'll have to meet to enjoy this benefit. For example, the prepaid interest has to go toward a mortgage on your primary home, not a vacation home.
Prepaid interest also protects you from a rising interest rate. Given that prepaid interest typically covers a short timeframe, it may be unlikely that you'll see significant interest rate movement. However, if the rate does change, you'll be protected because you've already paid the interest.
Also, while coughing up the extra cash for prepaid interest might hurt at the moment, a new homeowner will have many more purchases to make during their initial weeks in their new home. Prepaying some of your interest will ensure better budgeting as you fill your new home with furniture, decorations, and appliances.
Prepaid interest will help you avoid higher than expected mortgage costs, which can be crucial during those early months of filling your home with belongings.
The Bottom Line
To recap, prepaid interest is a payment that's typically required at the closing of a home sale or on the day a homeowner refinances their mortgage. The most common prepayment timeframe captures interest that will accrue between the day of closing and the first day covered by the first mortgage payment.
However, anytime interest is paid before it accrues, that payment qualifies as "prepaid interest." It doesn't have to cover mortgage interest, that's simply the most common scenario in which people encounter these types of payments.