What is Prepaid Interest?

home owner 2On your cost estimate worksheet or Good Faith Estimate, you see “Prepaid Interest” for several hundred dollars.

What is this? Is it a junk fee? Do I really have to pay that? These are questions people have been asking me.

Prepaid interest is not a fee. It is actually a partial mortgage payment. I will explain.

If you close your loan on June 15, then you will own your home from June 16 to June 30. For those 15 days of ownership, the lender does not send you a bill for a partial mortgage payment; instead, it is included in your closing costs.

If you close on June 30, you will have only one day of prepaid interest, because you will own your home for only one day in June.

If you close June 5, you will have 25 days of prepaid interest.

Prepaid interest is calculated to be exactly fair. You pay for the days you own your new home from the date of funding to the end of the month.

Before you have a contract on a house, the loan officer doesn’t know which day of the month you might close; therefore, most lenders will select 15 days of prepaid interest. The most conservative lenders will select 30 days of interest, ensuring that the cost will not go up. Some lenders, in an effort to make their estimate appear cheaper than their competitors, select one or two days of prepaid interest. In this case, you will most likely see a higher charge at closing, unless you truly close at the end of the month.

Which is the Best Day to Close?

The best day to close your loan is the day you want to take ownership of the new property. For many people who are renting, the best day for them to move out of their apartment or rental house is at the end of the month. However, some people want two weeks’ lead time so they can paint and clean. In that case, taking ownership in the middle of the month works better.

Be aware that the seller might put in a clause that says closing is June 15, but occupancy is June 20. This means you will own the house on June 15 and pay the prepaid interest from that day, but you cannot move in until June 20. You are giving the sellers five days to move out and you are paying for those days for them. If you don’t like that arrangement, speak with your Realtor about the closing date matching the occupancy date.

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