Definition and Explanation of Prepaid Interest

prepaid interest
Many real estate agents do not know how to explain prepaid interest. © Big Stock Photo

Definition: What is prepaid interest? The simple, universal answer is interest that is paid in advance. You will most often hear this term used in association with a principal and interest payment for a mortgage, which is short for a PI payment.

Unlike rent for an apartment, which is paid in advance, mortgage interest is paid in arrears. A payment in arrears results when you make a mortgage payment on April 1, for example, as it pays the interest for the month of March.

Not like rent. Rent is paid from the first to the end of the month, in most usual situations. Sometimes, if you move into a home the last week of the month, a property manager might prorate the rent to the first of the month, and collect one month plus a prorata portion for that additional week, but it is always paid in advance. Like they don't trust a tenant to pay. Which is why sometimes bank are viewed as more trusting, even though they are not. Because interest for a mortgage is paid in arrears to the creditor.

Borrowers typically prepay interest when they take out a loan to either buy a home or to refinance an existing mortgage. A borrower or new home buyer will pay interest up to the day that is 30 days away from their first mortgage payment.

This means if you close the transaction on, say, March 15th, your first mortgage payment will be due on May 1. It may seem like whoa, April is free, but it is not.

That's because the May payment will pay the interest for April. However, the amount due for the period between March 15th and March 31st will be paid by the borrower at closing. That portion is called prepaid interest.

When the payment is paid in May, if the payment is due on the first on May, interest will be paid up to the first of May, and the principal portion will be deducted from the unpaid balance of the loan, resulting in a new unpaid balance that is good to May 1 (for payoff purposes).

To illustrate, let's say the original unpaid balance of a mortgage loan is an even $200,000, bearing interest at 5% per annum, with a principal and interest payment of $1,703.64. After making payments for 11 months, the unpaid balance is now $197,300.83. You make a payment for December 1 on December 1 of $1,073.64. If you take the previous unpaid principal balance of $197,300.83 x 5% and divide by 12 months, you will get a new monthly interest portion of $822.09.

As time goes on, a homeowner pays a larger percentage of the payment toward principal every month than toward interest. Principal payment portions rise and interest payment portions decrease. Now, if you subtract the new monthly interest portion of $822.09 from the PI payment of $1,073.64, your new portion of principal paid toward the balance is the difference between those two numbers, or $251.56.

Now, you take the unpaid principal balance from November of $197,300.83 and deduct the principal portion for December, and your new unpaid principal balance up to December 1 is 197,049.27.

Suppose after making your December 1 payment, you decide it is now time to move and sell your home because a sudden upward tick in appreciation for your neighborhood unexpectedly makes your home worth $300,000.

Hey, you can dream, right? Upon selling, the bank will demand additional interest paid to the date of receipt of funds. This means you will owe $197,049.27 plus daily interest of $27.37 to the bank, up to the final date when the bank receives the money.

To recap, prepaid interest is paid at the inception of your loan up to the first payment due date, and additional interest is paid when your loan is paid off, up to the date the creditor is paid.

At the time of writing, Elizabeth Weintraub, CalBRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.