Mortgage Matters: Understanding prepaid interest with your mortgage loan (column)
Mortgage Matters
When closing on the financing of either a refinance or a purchase transaction, interest on the loan will be collected from the borrower and prepaid to the lender upon funding of the loan. Easy enough, right?
Think of prepaid interest as the mortgage payment to the bank or the lender for the month in which you close. Prepaying interest at consummation of the transaction avoids having to make a mortgage payment to the bank or lender a few days or weeks after you close. As easy as this sounds, there are a few variables to keep in mind with prepaid interest.
Starting with a specific illustration, let’s assume you are going to close and fund on the purchase of a new home on Nov. 15 with a loan amount of $350,000 at an interest rate of 4 percent. Rounded slightly, the per-diem interest on the loan is $40. At closing, you will prepay the lender interest from Nov. 15 to Dec. 1, or 16 days. Sixteen days of interest at $40 (plus or minus) per day is roughly $640 you will pay the lender at closing.
While prepaid interest is factored or lumped into the costs of the loan, the prepaid interest is not technically a true closing cost of the loan. True costs of a loan, or closing costs, can be broken down to items that you will pay in order to complete the transaction, such as appraisal fee, credit report fee, flood certificate, lender fees, origination fees, recording fee, title fees, etc.
Borrowers incur interest on the loan simply by owning the home and carrying mortgage. Even though the prepaid interest, real estate taxes and insurance premiums for the home appear on the settlement statement and are costs incurred by the borrower at closing, they are technically not true fees of a loan or closing costs.
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Reducing Total Cost
If the closing occurs within the first five or seven days of a month, most lenders and banks will offer a credit to the borrowers for the days of interest, as opposed to collecting 25 or 30 days of the interest. Structuring the interest as a credit versus a prepaid item can reduce the overall cost of the loan and can help reduce the total amount due from a borrower. This can be a key variable in many instances with a purchase transaction or even a refinance.
But if the interest is credited back to the borrower as opposed to being collected in advance, the first monthly payment due from the borrower to the lender will be set in the next calendar month. Whereas interest prepaid or collected in advance typically means the borrowers will not have a payment for one additional month out of pocket.
For example, if a loan closes and funds on say Nov. 5, under the same terms outlined above, interest credited for five days would mean $200 (plus or minus) credited to the borrowers off of the closing costs. In this scenario, the first mortgage payment from the borrowers would then be due in December. Whereas, 26 days of interest collected from the borrowers for the remainder of the month of November would be $1,040 (plus or minus) collected or due at closing for the month of November. But in this case, the first mortgage payment would be due in January.
Understanding prepaid interest is a key factor when analyzing exactly how to structure a mortgage. As outlined here, it can be a little difficult to properly understand and requires the advice and insight of a seasoned mortgage professional.
William A. DesPortes works for Central Rockies Mortgage Corp. He can be reached at 970-845-7000, ext. 103, and williamd@centralrockies.com.