Prepaid interest loans: why the money that lands is less than the loan

You are told you have been approved for $300k. Settlement day comes, and the amount that reaches your account is $283,500. Nobody has made a mistake. Six months of interest and a fee were taken out before the money moved.

That is prepaid interest, and it is common enough in short-term business lending that every owner who borrows against property should know how to plan around it.

What does prepaid interest mean in practice?

On most loans you pay interest after it accrues, month by month. With prepaid interest, the lender takes interest for a block of months up front, usually out of the advance. In return you make no interest repayments during those months.

The glossary definition of prepaid interest is short. What matters to you is how it changes three things:

• Cash in hand. It is lower than the loan amount.
• Monthly cash flow. It is lighter, because nothing goes out for the prepaid period.
• Early repayment. It becomes a question of whether unused interest comes back.

You will most often meet it on caveat loans, bridging and other private or short-term loans of a few months to a year, where the plan is to repay in one go from a sale, refinance or incoming payment.

How do you work out how much to borrow?

This is the step that catches people out. Say you need $300k in hand to complete a purchase. If you ask for $300k, you will land short. So you gross up.

Here is an illustrative case. The lender’s prepaid interest for six months, plus its establishment fee, comes to $5.50 of every $100 on the facility. To get $300k net:

Facility = $300,000 ÷ (1 − 0.055) = about $317,460

	Amount
Facility size	$317,460
Six months prepaid interest	$13,000
Establishment fee	$4,460
Cash you receive	$300,000

Two lessons here. First, the deductions are $17,460, not the $16,500 you would get by applying the same share to $300,000, because interest is charged on the bigger facility. Second, you will owe $317,460 at the end, not $300,000. Your repayment plan has to cover the larger number.

If you’re unsure about the arithmetic, ask the lender to confirm in writing: “To receive $300,000 at settlement, what facility amount do I need?” Our caveat loan calculator is a good place to test the shape of these figures, and the true cost guide shows how to add up the rest.

Already staring at a settlement date? A quick enquiry gets the right lenders looking at it.

Which is better: prepaid or paying monthly?

Neither is always better. They are different ways to feel the same cost.

	Prepaid	Pay monthly
Cash at settlement	Lower	Higher
Cash flow during the loan	No interest payments	Interest each month
Risk of missed payments	Low during the prepaid period	Present every month
Early repayment	Refund question	Stop paying when you repay
Lender’s view	Simple, low admin	Needs a payment history

Prepaid tends to suit a borrower who has a certain end date and doesn’t want to manage payments in the meantime. Monthly suits a borrower who might repay early or who needs every dollar upfront. Some lenders let you choose, and it is reasonable to ask whether you can pay monthly instead of prepaying.

The big question: what if you repay early?

This is where prepaid interest can cost real money, and where lender contracts differ most.

Suppose the same $317,460 facility has $13,000 of prepaid interest for six months, about $2,167 a month. A sale completes early and you repay at the end of month four. Two months of interest, around $4,333, are unused.

• Full refund of unused interest: you get about $4,333 back. A fair outcome.
• Refund minus a minimum period: the lender may say the minimum term is three months, so you get back only the months beyond that. In this example, you’d recover just one month.
• No refund: you’ve paid six months of interest for four months of use, and the unused part is gone.

Neither of these is necessarily unreasonable, because the lender has costs and has priced the loan around a minimum return. The problem comes only if you didn’t know. Ask: “If I repay at month three, month four and month five, what do I get back, in dollars?” and get the answer in writing. Our guide to early repayment savings and penalties covers how these terms are usually built.

What if the loan runs longer than planned?

Sales fall over. Refinances take longer than expected. Settlements slip. If your loan lasts past the prepaid period, the contract decides what happens next, and the options include:

• Interest reverting to monthly, at the standard pricing
• A further period of interest deducted from remaining funds, or added to the balance (which makes it capitalised interest)
• Default or holdover pricing, usually higher
• An extension fee as well as interest

Before you sign, ask what one extra month would cost in total. If the answer is large, build a buffer into your timeline and your plan. A realistic exit matters more than a low headline cost, and the guide on exit strategies for short-term loans is a useful stress test.

How does prepaid interest work for tax?

Interest on money borrowed for business is generally deductible, but the timing of a prepayment needs thought. The ATO says a small business entity can claim an immediate deduction for a prepaid expense under the 12-month rule when the period it covers is 12 months or less and ends before the end of the next income year. If the period is longer, the deduction is spread across it.

So a six-month prepayment made on 1 June might be claimable in the income year it was paid, for a business that qualifies. That could help or hurt depending on your income that year, so don’t rely on it alone. Your accountant knows your position and can advise whether and when to claim.

Should you take prepaid interest?

Think of it as a trade. You give up cash today, and you get certainty and a month-by-month break from repayments. Weighed against the alternatives:

• Take it if the loan is short, the exit date is solid, the refund terms are fair, and the net amount still does the job.
• Think twice if you may repay early under a no-refund clause, you can’t gross up enough to cover your need, or the deductions are a big share of the advance.
• Compare it with a loan where you pay monthly, which may have a slightly different price but more flexibility. Our guide on interest-only business loans sets out that comparison.

If a bank has offered you a facility, those terms are often more flexible and cheaper, so weigh them seriously. Prepaid structures usually belong to private and short-term lenders, and they exist because those loans are short and exit-driven.

Questions to put to the lender

1. How many months of interest are prepaid, and in dollars?
2. What facility amount gives me my target net amount?
3. What is refunded if I repay at months two, three, four and five?
4. Is there a minimum interest period?
5. What happens, in dollars, if the loan runs a month over?
6. Can I pay interest monthly instead?

Small businesses are also protected against some one-sided contract terms. If a clause on keeping unused interest or on extension pricing seems out of balance, you can raise it with the lender and, if needed, get advice. The Australian Small Business and Family Enterprise Ombudsman is a starting point for small business disputes.

Planning a short-term loan?

If you are lining up a settlement and need to know how much to borrow to land the right amount, bring us the details. The form takes around a minute. Putting it in doesn’t register against your credit file. Your information stays with us instead of going to a crowd of lenders, and a team member reads it and phones you. Spell out the amount you need in hand, the security and when you expect to repay, and we’ll know what to look for.

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