Interim or pre-paid interest
I have had a couple of inquiries recently about mortgage interest lately so I thought I would post a few bits of information about how interest is accrued on a mortgage. Interest is paid in arrears. Your monthly mortgage payment is always applied to accrued interest first, assuming your payments are up to date. In other words, your April mortgage payment will pay for March's accrued interest. Simple enough, right?
It is customary that a borrower pays for interim interest at closing. This means that if you closed on your new home loan on April 15th, there are 15 days remaining in April. Rather than make your first payment due on May 1st so you can pay that remaining 15 days interest, the lender will require you pay that interest up front at closing. This will make your first payment due on June 1st. The June 1st payment will pay for May's interest.
This works the same if you close on any other day of the month (generally - I will explain further in the next paragraph). If you close on the 28th of May, you pay the remaining days worth of interest at closing and your first payment will be due on July 1st. The July 1st payment will pay for June's interest. With me so far? I hope so.
There is a couple of exceptions to this rule.....
First exception: If you close between the 1st and the 7th of the month, sometimes the lender will give you a credit for those days and require your 1st payment on the 1st of the following month. Example - If you close on April 3rd, the lender may give you 3 days worth of interest as a credit on your closing statement and then charge you 30 days interest on May 1st. This isn't always the case but it happens. More often that not, you will have the option to structure your loan this way or pay the remaining 27-28 days worth of interest in April at closing and have your first payment due on June 1st.
Second exception: Sometimes the lender will take the remaining days worth of interest and combine it with the payment that is due the month after next. Example - If you close on April 15th, there are 15 days left in the month. Rather than collect the interest for the remaining 15 days at closing, the lender will combine those 15 days worth of interest with the next months interest and collect it all with your first payment. If you close on April 15th, your June 1st payment will pay for May's interest AND the remaining days worth of interest in April. This means that your first payment will be higher than the 2nd and consecutive payments.
I hope this sheds a bit of light on interim interest (sometimes called pre-paid interest) and the way interest is paid on your home loan.
Posted by Jason Lash at 9:25 AM