What Is Prepaid Interest?
Definition of Prepaid Interest
Where income taxes are concerned, Prepaid Interest is “expensed out” over the course of the financing or loan. It typically refers to that type of interest incurred by a debtor prior to actual repayment of the original debt. Where mortgage loans in real estate are concerned, prepaid interest can refer to the amount of interest accruing from the actual settlement date until the start of the initial mortgage period. For instance, the “points” are a type of fee in the process that is considered to be a form of prepaid interest.
Additionally, it should be noted that any interest paid at the time of closing for the remaining portion of that month is labeled as prepaid interest as well. Interest is typically paid at the start of the month so technically, should your purchase occur in the middle of any month, you have paid no interest to date for that particular month. Therefore, it becomes necessary to pay for the remainder of the month at closing.
An Overview of Prepaid Interest
The most common misconception about prepaid interest is that it functions similar to a lease or rent payment on an apartment, condo, or home. In other words, it is paid in advance prior to living in the dwelling during the ensuing month. This is completely false due to the fact that you are always paying in arrears where prepaid interest is concerned. Interest starts accruing the minute a new month begins. Additionally, the accrual process continues throughout every month, hence the payment being due at the start of the ensuing month.
The reasoning behind the way this functions is based in the fact that until you have technically borrowed the money for another month this interest has not technically been earned. The fact that windfalls of cash is a remote possibility during the loan period, and that this windfall would enable you to pay of any and all debts, is why the process was designed to function in this manner. Refinancing that loan is also a possibility that is considered.
In that particular case, the only interest that the bank or lender is entitled to relates to the amount of interest that has accrued up to the time that the loan was refinanced. However, when you do refinance or employ a purchase money loan initially, you will most likely be obligated to and responsible for the interest accrued by the new loan resulting at the end of that month. The reasoning behind this is one of an administrative nature in that it provides the bank or lender the amount of time they need to set up all the accounting necessary to manage that particular account.
They now have a 30-day cushion for between the initializing of the loan and the time that the very first payment on that loan is received. Basically, you will make an upfront or down payment to the prior lender for that part of the month pertaining to the original loan that you had with them.
