Understanding the concept of payment in arrears
Many people look at their mortgage statement and assume that the current balance is how much it would take to pay off the loan. The truth is that the interest on a mortgage is paid in arrears, so the balance is always lower than the payoff figure. Payment in arrears means that each month’s payment is actually paying the interest for the previous month (example: interest for January is actually paid with the mortgage payment on February 1). Compare this to the way you pay your electric bill – it is paid after the service is used.
The idea of payment in arrears means that whenever a mortgage is paid off, the amount owed is more than the current balance. A certain amount of interest is added for the time that has passed between the last mortgage payment and the date the loan is paid off. This amount will vary depending on the interest rate of the loan being paid off, the amount owed and the day of the month the loan is paid off. A good conservative estimate for the interest amount is about 75% of the current monthly payment. Add that to the current principal balance of the loan and you have a ballpark figure for a total payoff amount.
**Important note: FHA mortgages traditionally charged a full month of interest upon payoff regardless of which day of the month the loan was paid off. This policy has changed and FHA will no longer be able to charge a full month’s interest after January 21, 2015.**
The myth of skipped mortgage payments
When a person purchases or refinances a home with a new mortgage, they typically pay prepaid interest (sometimes referred to as interest per diem). Prepaid interest is a prorated amount of interest calculated by using the number of days remaining in that month and the interest rate. Prepaid interest is like a partial mortgage payment paid ahead of time and results in the 1st of the month passing one time without a mortgage payment. Many people refer to this as “skipping” a payment, but the reality is that the interest was already covered in the form of prepaid interest at the settlement.
Not all borrowers skip their next payment
There are a small percentage of loans that will not skip a monthly payment because they close right at the beginning of the month. These loans receive an interest credit at the closing rather than paying prepaid interest. When an interest credit is issued, the next mortgage payment will be due on the 1st of the following month. The closing paperwork on your loan should clearly define if this is the case or if you will be “skipping” a payment as most loans do. If you are unable to determine which scenario you fall into, just check your paperwork for the first payment letter or call your lender for clarification.
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