What Is Prepaid Interest? Here’s Why You Need to Pay the Mortgage Lender Ahead of Time

As the name implies, “prepaid interest” is money you owe to a bank or mortgage lender that is paid in advance of when it is actually due.

In terms of why it needs to be paid before the due date, there are several reasons, though it mostly boils down to the fact that mortgages are paid in arrears.

This means mortgage payments are due after the month ends, because interest must accrue (over time) before it can be paid.

This differs from rent, which is paid in advance of the month in which you occupy a rental unit.

If buying a home or refinancing an existing mortgage, prepaid interest will often be listed as a line item along with your other closing costs. Let’s learn why.

Prepaid Interest on a Home Purchase

Mortgages are generally due on the first of the month, though there is also typically a grace period to pay until the 15th.

Additionally, mortgage lenders don’t accept partial payments, so an entire month’s payment must be paid each month.

When you purchase a home, there’s a good chance you’ll close on a random day of the month, say the 10th or the 15th, or the 24th.

This means your mortgage will accrue interest for an odd number of days during that initial month.

Instead of asking you to pay that odd amount of interest as your first mortgage payment, you simply take care of it at closing.

By take care of it, I mean pay it in advance at a daily rate so you start with a clean slate once the loan funds.

Using one of our closing dates above, those who close on the 10th would owe 20-21 days of “per diem interest” at closing. Per diem simply means per day. It is also known as interim interest.

This ensures the lender is paid interest for the time you hold the loan and reside in the property, despite a full mortgage payment not being due yet.

However, as a result of that prepaid interest, your first mortgage payment is pushed out a month.

Remember, a full month of interest must accrue before a payment is generated.

So if your home loan closed on January 10th, you’d pay 21 days of prepaid interest at closing, but the first mortgage payment wouldn’t be due until Match 1st.

Why? Because you already paid the interest that would normally be included in your February 1st payment at closing.

And now you must wait until interest accrues throughout the month of February to pay that amount in March, along with a portion of the principal balance (the loan amount).

This is often referred to as “skipping a mortgage payment,” though it’s not really skipping, it’s deferring and paying the interest portion only.

Prepaid Interest on a Mortgage Refinance

prepaid interest

If you already own a property with a mortgage attached, interest accrues daily throughout the month.

Assuming you decide to refinance that loan by taking out a replacement loan, interest will be due on both the old loan and the new loan at closing.

Similar to a home purchase loan, the interest will be calculated by taking the mortgage interest rate and how many days each lender holds your loan.

This will be broken up between old lender and new lender, with interest before your closing date going to your old lender, and prepaid interest from closing date to month-end going to your new lender.

So if you close on January 20th, you’d pay 20 days of interest to your old lender and 11 days of interest to your new lender.

This way the full month’s interest is squared away when you close, and you can start fresh with no interest due.

Then after a month’s time, enough interest will have accrued to make a full payment, which will be due on March 1st.

For the record, the payment due on January 1st would cover interest for the month of December.

In terms of how that interest is paid, you’d owe daily interest to the old lender based on the current principal balance and mortgage rate.

For example, if your loan payoff was $250,000 and your mortgage rate 3.5%, daily interest would be roughly $24. That’s about $480 for 20 days.

On the new loan, you’d owe 11 days of interest based on the new loan amount and interest rate.

If we’re talking a rate and term refinance with a 3% interest rate, it’d be $20.55 a day for 11 days, or $226.

Together, you’d owe about $706 to both lenders for the month of January.

As you can see, interest is paid to both the old lender and the new lender at closing when it’s a mortgage refinance.

How to Calculate Prepaid Interest

While you shouldn’t have to calculate prepaid interest on your own, thanks to the escrow officer assigned to your loan, it’s good to know how it works.

You can also check their math and better understand how mortgage lending works.

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Let’s look at an example of prepaid Interest.

Loan amount: $200,000
Mortgage rate: 3%
Daily interest: $16.44

First, you take the mortgage rate and divide it by 365 (days) to determine the per diem interest amount.

For example, if the mortgage rate is 3%, it’d be .03%/365, or 0.00008219.

Next, you multiple that by the loan amount (we’ll pretend it’s $200,000) to get $16.44. I rounded it up from $16.438.

Finally, you multiple that amount by the days in which you’re required to pay per diem interest, which will be the total amount of prepaid interest due.

So if you need to pay it for 12 days, it’d be $197.28, and that would be included with your other closing costs, such as your loan origination fee, home appraisal, etc.

Tip: Prepaid interest isn’t a junk fee or an unnecessary add-on. It’s mostly unavoidable unless you close on the very last day of the month.

When Is the Best Time to Close Escrow?

  • Most home buyers choose to close at the end of the month
  • This can help keep closing costs down (including prepaid interest)
  • May also align better with your old rental lease if it renews on the first of the month
  • But if you close early in the month your first payment won’t be due for a long time

Ultimately, you don’t always get to pick when you close, whether it’s a home purchase or a refinance, but there are some considerations here.

If it’s a home purchase, closing late in the month means less prepaid interest will be due. And possibly less wasted rent will be paid out to your landlord.

For example, if you close on the 30th of the month and per diem interest is $50, you’d pay maybe $100.

And you wouldn’t have to pay another month’s rent assuming your lease renews on the first of the month.

Conversely, if you close on the 8th of the month you may owe roughly $1,150 in per diem interest at closing. This means higher closing costs, which could jeopardize your loan approval.

The caveat is your first mortgage payment wouldn’t be due for about seven weeks, versus four weeks for the mortgage that closes on the 30th.

So you get extra time until that first payment is due, which can be nice. And it’s also possible to receive a lender credit that covers the prepaid interest anyway.

Many transactions are structured as no cost loans these days, meaning the lender covers closing costs via these credits and they aren’t paid out-of-pocket directly.

The home sellers may also provide seller concessions to cover these costs.

The flipside is that the interest you pay doesn’t actually go toward paying down your loan amount and is basically just extra interest.

If you close near month’s end, beware that lenders are often extremely busy so there could be delays or mistakes.

If you close very early in the month, such as on the 4th, your lender may provide a “credit” for those days of interest and make your first mortgage payment due less than 30 days later.

The downside is your first payment is due the following month, but the upside is you don’t pay any unnecessary interest.

Best Day to Close a Refinance

  • Generally favorable to close late in the month to avoid higher closing costs
  • But the very last week of the month can be extremely busy and cutting it close
  • Also consider the rescission period that tacks on 3 days to your closing date
  • Signing loan docs on a Wednesday or Thursday could help you avoid extra interest charges

When it comes to a refinance, the same logic basically holds, though you’re paying interest to the old lender and the new lender.

Those who are refinancing to a significantly lower interest rate will want to get it done ASAP to avoid paying the higher per diem rate of interest.

You could argue avoiding the end of the month due to how busy lenders are, and maybe shoot for the third week of the month to keep interim interest at bay.

That would still give you five weeks or so until the first payment is due on the new refinance loan.

And as noted, a lender credit could absorb the interest paid to the old lender and new.

If you time it absolutely perfectly, it might be possible to skip two payments if you close early in the month, though this isn’t for the faint of heart.

Also consider the right of rescission, if applicable, which pushes your loan closing out at least three days.

If you sign docs on a Monday, the lender won’t be able to fund until Friday, and there’s a decent chance you pay “double interest” through the weekend if the old loan isn’t paid off immediately.

To avoid this, even though it’s not a major cost, you’d ideally want to sign on say a Wednesday or Thursday, then fund on a Monday or Tuesday.

Simply put, the earlier in the month you close, the longer it will be until the first payment is due on the new loan.

Tip: If you pay discount points at closing, these are also considered prepaid interest because you’re paying money upfront for a lower mortgage rate during your loan term.

(photo: Abhi)

Source: thetruthaboutmortgage.com

Why I Expect Mortgage Rates to Go Down Sometime Soon

If you thought 2021 was bad, just in general, you might think 2022 is even worse, if the subject happens to be mortgage rates.

They’ve started the year off with a bang, higher, and are now at their highest point in about two years.

A lot of market watchers expected mortgage rates to rise in 2022, but perhaps not this quickly and violently.

For example, the 30-year fixed finished the year 2021 close to 3%, and is now hovering around 3.5%, depending on the loan scenario in question.

It could be even higher than that depending on your FICO score and LTV ratio, and there’s fear things could get even worse.

A Big Jump in Mortgage Rates Is Often Followed by a Correction

Now I don’t want to be a sucker and try to time the market, but I’ve been thinking about this ever since mortgage rates shot up a week or so ago.

It seems like it came out of nowhere, despite the advanced warnings that the Fed would be raising rates this year.

The Fed thing was telegraphed and baked in, but the ongoing story has been inflation, which started off as “transitory” and lately became more concerning and perhaps permanent.

That has forced the Fed to get a bit more aggressive, prompting the dual stock market and bond market carnage we’ve seen lately.

At the same time, most 2022 mortgage rate predictions have called this, though just not this quickly.

There’s also a sense that the worst is behind us with COVID, even if omicron is leading to record numbers in all categories.

I’m hearing a lot of pandemic becomes endemic…emphasis on end.

So Much Bad News Yet Mortgage Interest Rates Are Higher?

mortgage rate trend

While it’s decidedly gloomy out there, here’s why I think mortgage rates might actually get cheaper next month.

If you look at short periods of volatility, they’re usually followed by a correction, whether it’s up or down. This seems to apply to most things, most notably the stock market.

Because mortgage interest rates surged so quickly, there’s a good chance they could fall back to earth for that very reason alone.

Simply put, too much selling makes something oversold and ripe for a purchase, in this case mortgage-backed securities (MBS).

Just look at this 30-year fixed chart from MND, which shows periods of rate spikes, followed by some correcting.

It’s obviously not a perfect science, and still a risk, but I could see rates taking a breather in February. Or perhaps March.

There are other factors working in favor of that argument, like surging COVID cases and hospitalizations.

Yes, we’ve all heard that the omicron variant is “mild,” but somehow daily cases are set to triple the record set a year ago.

And some 132,646 Americans are currently hospitalized with COVID, above the 132,051 record set in January of last year.

While it seems like everyone has COVID, it seems fewer are getting severe disease, despite the hospitalizations.

There’s also a sense that this was expected, seeing that we’ve been through a bad winter already. And there was much more mingling this holiday season.

That could explain why mortgage rates haven’t gone down, but UP. But give it time and things could change direction.

And I think it’d be silly to think there isn’t a next variant on the horizon, even if it’s all media hype.

There’s also that psychology when you think something can’t possibly happen that it does. And right now, it’s hard to imagine mortgage rates improving.

Mortgage Lender Competition to the Rescue?

Lastly, consider mortgage lenders for a moment. While an everyday homeowner or prospective home buyer certainly won’t like a higher mortgage rate, lenders despise them.

A big rate surge like this one will tank their loan volume in a hurry and have them wondering about rightsizing their staff.

It’ll make a cash out refinance less attractive and put a rate and term refinance out of reach for millions of homeowners.

When volume drops, lenders have to get more aggressive pricing-wise to stay afloat. It might mean making less per loan to get the loan to begin with!

And as I’ve written about before, it can be wise to apply for a home loan when it’s not busy.

Not just because your loan will get to the finish line faster, but because it should be cheaper, relatively speaking.

Why? Because the lender is willing to shrink their profit margin to get your business. When they’re slammed, they’ll maybe even ignore you.

So if it feels like all hope is lost on the mortgage rate front, it probably isn’t, for that reason alone.

When things turn around is another question. Does it happen in the next week or two, in February, or in March? Do things get worse before they get better?

I’m not sure, but I do think we could see a reprieve before the traditional home buying season gets underway in later March and April.

It might be short-lived though, so be ready to pounce if and when it happens.

Read more: What time of year are mortgage rates lowest?

Source: thetruthaboutmortgage.com

FHA vs. Conventional Loan: These Charts Can Help You Determine Which Is Cheaper

It’s time for another edition of mortgage match-ups: “FHA vs. conventional loan.” Our latest bout pits FHA loans against conventional loans, both of which are extremely popular loan options for home buyers these days. In short, conventional loans are non-government mortgages, typically backed by Fannie Mae or Freddie Mac. Whereas FHA loans are government-backed mortgages… Read More »FHA vs. Conventional Loan: These Charts Can Help You Determine Which Is Cheaper

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Source: thetruthaboutmortgage.com

FHA-to-Conventional Refinance: How to Drop Mortgage Insurance Once and For All

While refinance applications seem to be slowing, there are still some good reasons to refinance your mortgage, even if interest rates aren’t currently at their best. First off, let me preface this with the fact that mortgage rates are spectacular. Yes, the 30-year fixed used to be in the mid-2% range, but a rate of… Read More »FHA-to-Conventional Refinance: How to Drop Mortgage Insurance Once and For All

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Source: thetruthaboutmortgage.com

Mortgage Rates vs. Omicron

Last week, the World Health Organization (WHO) designated Omicron, formally known as B.1.1.529, a variant of concern. This news rocked financial markets nationwide amid concerns of another series of lockdowns, travel restrictions, and so on. In short, there’s renewed fear that we’re not out of the woods on COVID, as some seemed to think prior… Read More »Mortgage Rates vs. Omicron

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Source: thetruthaboutmortgage.com

2022 Home Selling Tips to Get Top Dollar: Don’t Take the Red Hot Real Estate Market for Granted

While the recent stock market boom, coupled with near-record low mortgage rates will undoubtedly make prospective home buyers feel richer, lofty asking prices may have the complete opposite effect. Regardless of what happens to the economy this year, chances are that those who are planning to buy a home will, assuming they can find one… Read More »2022 Home Selling Tips to Get Top Dollar: Don’t Take the Red Hot Real Estate Market for Granted

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Source: thetruthaboutmortgage.com

Zillow Offers Shuts Down Because It Can’t Forecast Future Home Prices, 25% of Workforce to Be Let Go

In a somewhat strange turn of events, the iBuying unit of Zillow, known as Zillow Offers, is shutting down after an initial suspension late last month. I call it strange because it’s happening at a time when the real estate market has never been hotter. You would think that any entity or individual who purchased… Read More »Zillow Offers Shuts Down Because It Can’t Forecast Future Home Prices, 25% of Workforce to Be Let Go

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Source: thetruthaboutmortgage.com

Mortgage Rates vs. Home Prices: Is There Really an Inverse Relationship Between Them?

Mortgage Q&A: “Mortgage rates vs. home prices.” Today, we’ll take a look at the impact of both home prices and mortgage rates on your decision to buy a piece of property, along with the relationship they share. Obviously, both are very important not only in terms of whether you should buy (from an investment standpoint),… Read More »Mortgage Rates vs. Home Prices: Is There Really an Inverse Relationship Between Them?

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Source: thetruthaboutmortgage.com

2022 FHA Loan Limits: Floor Rises to $420,680, Ceiling to $970,800

Similar to the FHFA, the U.S. Department of Housing and Urban Development (HUD) announces maximum loan limits each year for FHA loans.

Today, they unveiled the 2022 FHA loan limits, which like the 2022 conforming loan limits, will be significantly higher than the limits in effect this year.

This is thanks to continued home price appreciation, and the fact that the calculation of the FHA loan limits is driven by the conforming loan limit itself.

To come up with the FHA loan limits, HUD uses a percentage of the national conforming limit to set both a floor and a ceiling.

In cities like Los Angeles, home buyers can enjoy the higher ceiling loan limit, while many less expensive cities nationwide are set at the floor. There are also limits in between these two thresholds.

FHA Low-Cost Area Loan Limits (The Floor)

One-unit property: $420,680
Two-unit property: $538,650
Three-unit property: $651,050
Four-unit property: $809,150

To calculate the FHA loan limit floor, HUD uses 65 percent of the national conforming limit, which will be $647,200 for a one-unit property in 2022.

That puts it at $420,680, up from $356,362 in 2021. That’s a big 18% increase, and enough to make many more home buyers eligible for FHA financing nationwide.

It’ll be even higher for multi-unit properties, such as duplex or triplex.

If you put down the minimum 3.5% on a home purchase, you’ll now be able to purchase a property for as much as $435,000.

FHA High-Cost Area Loan Limits (The Ceiling)

One-unit property: $970,800
Two-unit property: $1,243,050
Three-unit property: $1,502,475
Four-unit property: $1,867,275

In more expensive metros nationwide, HUD allows for even higher loan limits, known as high-cost area mortgage limits.

These are set at 150 percent of the conforming limit, which matches them up with the high cost loan limits for mortgages backed by Fannie Mae and Freddie Mac.

As you can see, a four-unit property permits a near-$2 million loan limit, which tells you just how high home prices have risen.

This means a home buyer in Los Angeles could purchase a $1.5-million-dollar triplex with just $52,500 down. That’s pretty amazing.

Aside from the floor and ceiling, there are many metros that fall between these two limits throughout the country.

For example, the maximum loan limit for an FHA loan on a one-unit property in Denver, Colorado will be $684,250 in 2022.

Similarly, home buyers in the Miami-Ft. Lauderdale area will enjoy higher loan limits of $460,000 next year.

And in Phoenix, Arizona it will be $441,600, up from $368,000 in 2021. The same goes for Atlanta, where the 2022 FHA loan limit will be $471,500.

2022 FHA Loan Limits for Special Exception Areas

One-unit property: $1,456,200
Two-unit property: $1,864,575
Three-unit property: $2,253,700
Four-unit property: $2,800,900

Lastly, there are even higher loan limits for so-called special exception areas, which include Alaska, Guam, Hawaii, and the Virgin Islands.

They are adjusted higher to account for more expensive construction costs in these states and territories.

For a four-unit property, this loan limit is nearing a staggering $3 million, which tells you the dollar just ain’t worth what it used to be.

Regardless, this means a lot more home buyers will be able to take advantage of an FHA loan vs. a conventional loan.

Note that these are all forward mortgage limits for calendar year 2022, which are effective for case numbers assigned on or after January 1st, 2022.

For reverse mortgages, also known as Home Equity Conversion Mortgages (HECMs), the maximum nationwide claim amount will rise to nearly $1 million dollars ($970,800) for all cities.

If you were on the cusp of FHA loan eligibility because of a loan limit issue, you may want to take a second look at your loan scenario.

Source: thetruthaboutmortgage.com