The Surprising Impact of Prepaid Interest

Prepaid Surprise

Series: Apples To Apples — Unraveling the Mysteries of Bridge Loans and Hard Money Loans

Series Synopsis: In the bewildering pool of bridge loans, little differences can make a big splash. This series compares loans with terms that differ slightly, revealing surprising, substantial, and often overlooked differences.

Background

You’ve found an opportunity that requires funding in the next 15 days. Luckily, you own real estate and decide that a hard money loan is the quickest and easiest route to the cash you need. You’re considering two $500,000 cash-out loan offers. Both are 360-day loans at a 9% interest rate, but there’s a twist — one lender asks for all the interest upfront, while the other only wants the remaining 15 days of the month prepaid.

Just how much more appealing is the offer with only 15 days of prepaid interest?

Assumptions:

• Both loans come with an origination fee of $7,500 (or 2.5% of $500,000)
• Other costs, including title insurance, settlement agent fees, recording costs, and other transaction fees, add up to $2,000

Let’s unravel the enigma of prepaid interest and how it affects your loan.

Prepaid Interest Uncovered:

At the outset, prepaid interest is the interest you pay at loan closing, covering the gap until your first mortgage payment kicks in. It’s a variable creature, changing with the number of days between closing and your first payment. For instance, if your loan starts on June 28th, you might prepay interest for the 28th, 29th, and 30th of June at origination. While July’s monthly payment (due at the end of July or, depending on the loan, the first of August) will cover the whole month of July (interest due and paid at the end of the interest period is sometimes referred to as paying “in arrears” as opposed to prepaid which is paid before the interest period).

Sometimes, loans require a lot more than a few days of prepaid interest — they may require you to prepay interest for several months or even the full loan term.

This brings us to the heart of our discussion: the surprising and real difference for borrowers between 15 days of prepaid interest and 360 days of prepaid interest.

Scenario 1: 15 Days of Prepaid Interest:

Here, the prepaid interest is for 15 days. With a 9% interest rate and a $500,000 loan, this sums up to $1,875 (500,000 * 9% / 360 * 15). Add in the origination fee ($7,500) and other costs ($2,000), and the total upfront charges come to $11,375.

So, from the initial $500,000, the borrower pockets $488,625 at origination. Over the loan’s 360-day term, the interest, including the prepaid amount, totals $45,000 ($43,125 beyond the prepaid interest of $1,875). Add in the upfront charges, and the total cost of the loan is $54,500. Therefore, the borrower’s cash-out is $488,625, with interest making up ~9.2% and total costs around ~11.2% of the cash-out.

We will further use the following simplifying assumptions for this scenario: (1) That the borrower needs to make interest-only payments at the end of every month, and (2) that payment is made on the last day of the month (in reality, payments may need to be made a day or two earlier because of payment method or holidays, Sundays, etc.).

Scenario 2: 12 Months (360 days) of Prepaid Interest:

In the 360 days prepaid scenario, the prepaid interest amount swells to $45,000 (500,000 * 9%), engulfing all the loan’s interest. When we bundle this with the origination fee and other costs, we again get $54,500. However, having paid all the interest upfront, the borrower walks away with $445,500 at origination. The interest remains at $45,000, but now that is over 10% of the cash-out, and with the total costs, it balloons to ~12.2% of the cash-out.

We will further use the following simplifying assumption for this scenario: No payments are due or will be made before the maturity of the loan at 360 days.

The Bottom Line:

“cash-out” refers to money received at closing/origination

Under the 15-day prepaid interest scenario, the borrower walks away with an extra $43,125 at origination. Yes, that extra will be paid back as interest payments over the term of the loan, but it means the effective interest rate you are paying is much less with the 15-day prepaid interest scenario. With the lower prepaid interest payment, you could take out a smaller loan, or if you need the extra cash to make the monthly interest payments, you can put that extra cash in an interest-bearing bank account and earn interest while using it to make monthly payments.

From the lender’s perspective, how much better is 360 days of prepaid interest vs. 15 days? There are several factors that would go into that analysis and influence the outcome, but for the purpose of this article, we will assume the loan the made on June 16th, the lender keeps the origination fee (not paid to a broker), and there is not a leap year during the loan (i.e., the following February is 28 days long) and compare using a simple Internal Rate of Return analysis. Remember, from above, we are assuming payment is made on the last day of every month.

The above charts represent the cashflow and IRR from the lender’s perspective (Most loans would probably have fixed monthly payment amount, and payments may not come in on the exact due date, but this gives a directional approximation)

From the lender’s perspective, the 360-day prepaid interest loan results in more than a 0.5% higher internal rate of return (not to mention less risk for the lender since less money has been sent out).

Hence the lender earns a higher return with the larger amount of prepaid interest, and the borrower is paying a higher effective rate on the actual funds distributed. It is possible some borrowers may prefer the full-term prepaid interest just to avoid the administration of making monthly payments or for some other reason(s), but the borrower should fully understand the trade-offs.

Carefully consider the prepaid interest and other factors to understand the true cost of a loan. Also, remember all other costs associated with the property that will still need to be paid for independent of the loan choice. Examples include taxes, insurance, maintenance and upkeep costs, HOA, fees, utilities, etc.

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