Over the years, we have had a lot of fun with discussions about prepaid interest…..this is the area where many borrowers believe if they refinance their home loan, they will be rewarded by the lender by being allowed to skip a payment. We might be that nice, but I can assure you lenders are not. Prepaid interest is also the reason many purchasers are told that it is better or less costly to close their transaction at or near the end of the month rather than earlier in the month. Let’s see if we add to the haziness of this concept or make it crystal clear with the details that follow.

First of all, we need to understand that lenders are in the business to earn a profit, hence, a “give away” is not a term they embrace. So don’t expect to “skip” a payment in a refinance situation. Lenders expect to be paid interest from the day they make the loan to the borrower until the day that loan is paid in full…..no more, no less.

Secondly, many borrowers equate monthly mortgage payments to monthly rental payments. While a monthly rental payment is typically due on the first day of the month and covers the rent through the end of the month, a monthly mortgage payment is somewhat different. When a borrower makes a monthly mortgage payment typically due on the first day of the month, that payment is covering the period for the prior month. That is, by making a mortgage payment due April 1st, you’re actually paying for the loan outstanding during the month of March. This is referred to as paying interest “in arrears”…..due today but covering a prior period vs. due today and covering a future period.

(For our example, we will assume that there are 30 days in the month of March instead of the actual 31 days.)

Interest In Arrears
Mar. pmt.	Apr. pmt.	May. pmt.
So then, when a borrower makes their April payment, it covers the loan outstanding from March 1st through March 30th . Likewise, when a borrower makes their May payment, it covers the loan outstanding from April 1st through April 30th , as illustrated below.
« Mar. pmt. 3/1-------------3/30 « Apr. pmt.      4/1-------------4/30 « May pmt.

Now, let’s assume that a borrower is refinancing their $250,000 interest only loan with an interest rate of 7.00% for a $250,000 interest only loan with a lower interest rate of 6.00%. The monthly payment and daily interest comparisons for each of these loans are as follows:

Let’s further assume that a borrower will be completing their refinance during the month of March and see what differences exist if the closing date of the loan is March 28th, March 15th or March 4th. Regardless of the March closing date, the first payment due to the new lender will be May 1st.

If the refinance closes March 28th , then the first payment is due in 33 days.

If the refinance closes March 15th, then the first payment is due in 45 days.

If the refinance closes March 4th , then the first payment is due in 57 days.

“comprende”?

“$1,125.09, $625.05 or $125.01? I’ll go for the end of the month.”

Not so fast! If you pay the new lender 3 days of prepaid interest at the new, lower interest rate equal to $125.01, you’re going to owe the old lender 27 days of interest at the old, higher interest rate equal to $1,312.47 (27 days at a per day amount of $48.61). If you pay the new lender 15 days of prepaid interest equal to $625.05, you’re going to owe the old lender 15 days of interest equal to $729.15. And, if you pay the new lender 27 days of prepaid interest equal to $1,125.09, you’re going to owe the old lender 3 days of interest equal to $145.83. As illustrated below:

So what really happens is this: The borrower’s last payment to the old lender is their March payment (covering the loan outstanding for the month of February). The borrower’s first payment to the new lender is their May payment (covering the loan outstanding for the month of April). In this situation, the borrower does not actually make an April payment directly to a lender. Rather, the borrower makes the equivalent of a mortgage payment to the “Title/Escrow Company” who in turn divides the payment received between the old and new lenders dependent, of course, on when the new loan is made and when the old loan is paid off.

Last pmt to old lender		First pmt to new lender
Mar. pmt. 1st --------------30th April pmt. 1st ---------------30th May pmt.
Equivalent of April pmt made to Title/Escrow Company who divides it between the old & new lenders

So then, the reason for the term “prepaid interest” is that this amount is paid before it would normally be due. Remember our example: the April payment covers the loan outstanding for the month of March, so if you’re paying it to the lenders through the
title/escrow company in March before it would normally become due on April 1st, it is properly labeled “prepaid”.

Back to Top