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What is Prepaid Interest?

Brenda Scott
Brenda Scott

In financial terms, interest is a set amount paid for the use of money, generally a percentage of the money borrowed or loaned. Interest is paid in arrears, or after the fact, because it is not due until the money has been used. Prepaid interest is interest paid in advance of being due. One of the most common places where prepaid interest is assessed is in procuring a real estate mortgage.

Mortgage prepaid interest is usually collected at the time of closing the mortgage, and includes the amount of interest that will come due for the remainder of the month when the loan closes. For example, if a loan closes on 15 October, the lending agent will withhold the interest for 15 October through 31 October, which normally would be due on the 1 November payment. New loans, however, usually do not require a payment to be made until the end of the first full month, which in the case above would be 1 December. This gives the lender time to set up the account and commence with regularly scheduled payments.

Man climbing a rope
Man climbing a rope

Another form of prepaid interest charged on some real estate transactions is referred to as discount points, or loan origination fees. Points are actually interest paid in advance in order to buy down a rate, or obtain a lower interest rate on the mortgage. These can be charged on both new purchases and refinanced mortgages, and are based upon a percentage of the mortgage amount. If a lender charges three points on a $100,000 US Dollars (USD) mortgage, then he is charging $3,000 USD in prepaid interest.

A person should be very careful, however, when agreeing to pay points. In the US, the average homeowner moves or refinances within five years. It is important to calculate the difference in the amount of interest that would be paid on the loan without the discounted rate, and compare it to the amount of interest that would be paid at the new rate plus the amount paid in points.

Some countries, such as Belgium, Denmark, Greece, Ireland, Italy, the Netherlands, Norway, Sweden, Switzerland, and the United States allow an income tax deduction for mortgage interest payments to both individuals and businesses. Other jurisdictions, like the UK, only allow the mortgage interest deduction for businesses. As a general rule, however, the deduction does not include prepaid interest, but only that interest which should have been charged for the current year. The prepaid interest will become deductible in the year that it should have been assessed.

The United States tax code makes one exception to this rule, in dealing with prepaid interest in the form of discount points paid on a mortgage to secure a personal residence. If this is an initial purchase, then the taxpayer has the option of claiming all of the points paid in the year of purchase, or amortizing the points over the life of the mortgage or until the mortgage is paid. Points paid for business or rental property, or to refinance a personal residence, must be amortized.

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