When you buy a home, you’ll often see “prepaid daily interest” listed as a closing cost. This is the interest charged on your mortgage for the days between your closing date and the last day of that month. Mortgages are typically paid in arrears, meaning your monthly payment covers the interest for the prior month — so your first regular mortgage payment will be due on the first of the month after closing, covering interest for the whole previous month.
Because of this schedule, lenders require you to pay the interest that accrues from the day you close on your loan until the end of that month upfront, at closing. This prepaid interest “bridges the gap” so that when your first full mortgage payment comes due, it covers a complete month’s interest and principal, along with taxes and insurance (commonly called PITI).
You can think of prepaid daily interest like a pro-rated rent for the days you actually occupy your home in the first month. For example, if you close on May 20th, you only pay interest for May 20th through May 31st at closing, rather than paying for the entire month of May.
Calculating prepaid daily interest involves these steps:
- Calculate the annual interest by multiplying your loan amount by your interest rate.
- Divide this annual interest by 365 (or 366 in a leap year) to find the daily interest amount.
- Count the number of days from closing through the end of the month, including the closing day.
- Multiply the daily interest amount by the number of days to get the prepaid interest you owe.
For instance, on a $400,000 loan with a 6% interest rate closing on May 20th:
- Annual interest is $400,000 x 0.06 = $24,000.
- Daily interest is $24,000 ÷ 365 = approximately $65.75.
- Days from May 20 to May 31 = 12.
- Prepaid interest = $65.75 x 12 = $789.
You can reduce prepaid interest by scheduling your closing later in the month, decreasing the number of days you owe interest before your first mortgage payment. However, end-of-month closings can be popular and prone to delays.
It’s important to distinguish prepaid daily interest from your first mortgage payment:
- Prepaid daily interest covers only the partial month from closing until the end of that month and is paid at closing.
- Your first mortgage payment, made on the first day of the following month, covers a full month’s principal, interest, taxes, and insurance (PITI).
Regarding taxes, prepaid mortgage interest is generally deductible in the year paid, similar to regular mortgage interest. You should receive IRS Form 1098 from your lender reflecting your mortgage interest payments, including prepaid interest. For detailed guidance, consult IRS Topic No. 505 on interest expense or discuss with a tax advisor.
Learn more about related concepts like Mortgage Interest Deduction and Mortgage Closing Costs to better understand your mortgage expenses.
Sources:
- Consumer Financial Protection Bureau: What is prepaid interest?
- IRS Topic No. 505: Interest Expense
- Investopedia: Prepaid Interest
