Mortgage Closings and Per Diem Interest
Many home loan borrowers are confused about a charge on their mortgage loan closing statement referred to as per diem interest. Part of the confusion stems from the fact that this charge is referred to as a closing cost on the good faith estimate provided to the borrower.
Per diem interest means the amount of daily interest payable under a home loan. The mortgage lender needs to calculate per diem interest in order to determine the amount of interest payable by a borrower at the loan closing.
At the loan closing, this will the daily cost of interest form the time the funds are disbursed to either purchase the home or after the three day right of rescission on a mortgage refinance to the time period when the mortgage interest starts to accrue for the first payment.
Most all home mortgages have loans monthly payments that cover a 30 day period of time due on the first of the month. A borrower’s first monthly payment is typically due the first day of the second month after closing. For example, if a loan closes on January 15, then the first monthly payment will be due on March 1 not February 1.
Interest paid on home loans is payable in arrears, using the above payment date example, the March 1 monthly payment will cover interest which accrued during the month of February. Normally, rent payments are calculated another way and are forward payments, the March 1 payment covers the rent for the month of March not February.
Following this same example, the borrower that would close on the home loan on January 15 has their first monthly mortgage payment due on March 1, whether the loan was a refinance or for a purchase. The borrower has a payment due on March 1st that covers all of February’s interest charges and any principal due, but the borrower had access to the funds from the time it disbursed in mid January. To cover the interest charges from January 15 to the February 1st, at the closing the borrower will have to pay interest covering that period from January 15 through January 31 since this interest will not be included in the March 1 monthly payment.
Per diem interest is determined by first multiplying the principal amount of the loan by the interest rate to determine the annual amount of interest payable under the loan. Next, the annual amount is divided by 360 days to determine the per diem interest amount (note mortgage lenders typically calculate per diem interest based on a 360 day year; when calculating per diem interest it always divided by 360 days unless the mortgage lender specifically instructs otherwise). Finally, the per diem interest amount is multiplied by the number of days remaining in the month of closing, including the date of closing.
For example assume that a loan with an original principal amount equal to $100,000 and an annual mortgage interest rate of 7.00% is funded on January 15. To determine all charges at the closing, the mortgage lender must determine the amount of per diem interest which will be payable by the borrower at closing.
The total annual interest is equal to $7,000 or 100,000 x 7%. This is interest for the year and therefore has to be divided by 360 to obtain the daily interest of $19.44. This figure is now multiplied by the 15 days remaining in the month to come up with a total interest charge of $291.60.
This charge will be depicted as a closing cost on the settlement statement but this would seem like a misnomer. The interest charge is simply the cost of having access to that money before the first mortgage payment, referring to interest charges as a closing cost in the same general category as origination fees can appear confusing.
How Mortgage Interest is Paid and Calculated
Home mortgage interest is any interest that is paid on a mortgage loan secured by a home. The mortgage loan can be for the purchase of a new home, a mortgage that has been refinanced or a second mortgage. On all of these home loans the repayment period will include monthly mortgage payments of principal and interest, unless the home loan has an interest only feature in which case the home loan will not include the repayment of principal. In the terms for the monthly mortgage payment on the home loans the mortgage interest that is paid with each total monthly mortgage payment is paid in arrears. This means that the principal and interest payment will pay for the 30 day period of mortgage interest before the payment due date. A home mortgage loan payment paid on the 1st of April is paying for the mortgage interest that accrued in March.
Every time someone closes on a home loan they will prepay the mortgage interest from the time the money is disbursed to the beginning of the next month. Then the first regular monthly mortgage payment is due on the following month. For example, you may have a March 15 closing on a home loan, and the mortgage loan agreement calls for the monthly payment to occur on the first of the month. At the closing you will be required to pay the mortgage interest for the remainder of the month of March at the loan closing, approximately half the month. However, your next payment is not due on April 1, but rather will be due May 1. The payment for April which is due on May 1 and all subsequent payments are made “in arrears” or for use of the money for the previous month.
When you engage in a mortgage refinance and see the payoff letter from your existing mortgage, you will notice it is higher than the principal balance. Since the payments are paying the interest in arrears, if you paid a June 1st payment and request to see a payoff for June, the payoff will have the interest due from June 1st to whatever day of that month you want the payoff good for. Each scheduled mortgage payment on a fully amortizing loan is divided between the interest due for the month and the principal amortization, which is the gradual reduction in the original mortgage loan balance.
It is easy to compute your unpaid principal mortgage loan balance after you make your first monthly mortgage payment. Let’s use a home loan of $200,000 with an interest rate of 6%. First, take your principal mortgage loan balance of $200,000 and multiply it times your 6% annual interest rate. The annual interest amount is $12,000. Divide the annual interest figure by 12 months to arrive at the monthly interest due. That number is $1000.
Since your fully amortizing payment on this home loan would be $1199.10, to figure the principal portion of that payment, you would subtract the monthly interest number ($1000) from the principal and interest payment ($1199.10). The result is $199.10, which is the principal portion of your monthly mortgage payment.
Now, subtract the $199.10 principal portion paid from the unpaid principal balance of $200,000. That number is $199800.90, which is the remaining unpaid principal balance. The next month’s monthly mortgage payment will have the same mortgage rate but the amount of interest paid on the loan will be slightly less because the principal balance of the loan is less. Therefore, the next monthly mortgage payment has a larger portion of the payment applied to principal and a smaller portion to interest. In the beginning period of the home loan, these numbers will seem inconsequential but as the numbers of monthly mortgage payments add up, the amount going to interest decreases as the mortgage loan balance decreases.
With each consecutive payment, your unpaid principal balance will drop by a slightly higher principal reduction amount over the previous month. This is because although the unpaid balance is computed using the same method every month, your principal portion of the monthly payment will increase while the interest portion will get smaller.
Note, these numbers are round numbers for purposes of simplicity of understanding. If you are paying off a mortgage loan, you must add daily interest to the unpaid mortgage loan balance until the day the mortgage lender receives the payoff amount. To compute daily interest for a mortgage loan payoff, take the principal balance times the interest rate and divide by 12 months, which will give you the monthly interest. Then divide the monthly interest by 30 days, which will equal the daily interest.
As an example you have $100,000 and you decide to pay off your mortgage on January 5th. You know you will owe $99,800 as of January 1. But you will also owe 5 days of mortgage interest. How much is that?
$99,800 x 6% = $5,988 ÷ by 12 months = $499 ÷ by 30 days = $16.63 x 5 days = $83.17 interest due for five days.
Figured precisely, you would send the lender $99,800.40 plus $83.17 interest for a total payment of $99,883.57.
Negative Amortization Mortgages
It was a mortgage deal that you read or heard about, that just seems too good to be true. A financial institution, bank or mortgage lender says they will allow you to make payments that are so small they do not even equal the current mortgage interest due. This home loan programs would drastically reduce your monthly payments and you were on easy street. Negative amortization mortgage are what this type of mortgage arrangement is called. And it only sounds good in most cases. Interest money you save now will cost you dearly later.
The typical monthly mortgage payment is mainly interest, charged for the use of the money you borrowed on the mortgage. At the start of the mortgage term, almost all of the payment you make each month is paid in interest, with a small portion toward the principal of the home loan. Over the period of the mortgage, gradually the amount paid toward the principal increases, and the interest you pay slowly decreases. This process is the amortization of the mortgage loan. A different type of home loan find mostly with adjustable rate mortgages is called a negative amortization mortgage and it is something not to be entered into lightly.
A negative amortization mortgage allows you to pay less interest for a set period of time, normally this may last for a few to several years. Lets say for discussion that your normal mortgage payment each month is $1000, and of that amount $600 dollars goes toward the interest amount and the rest, $400 dollars goes toward the principal. If you begin a negative amortization mortgage you would conceivably have the option to make a monthly payment of say, $500 dollars, which would pay on the interest and nothing on the principal of the loan. You would still be responsible for the other $100 dollars of interest. This other $100 dollars of interest is then added back into the principal of the mortgage loan, and you then will pay interest on this amount, too.
Negative amortization is made available by mortgage lenders by calculating two different interest rates. The first interest rate is referred to as the payment rate and the second interest rate is simply known as, fully indexed interest rate. On adjustable rate mortgages with negative amortization features, you will find that the payment rate changes are normally capped off at 7.5% of the previous payment amount. However, the true interest rate is calculated by simply the adjustable rate mortgage index plus the margin without the use of periodic caps. However, what the borrower pays is ultimately up to them because the borrower is able to choose which mortgage rate they wish to pay. Because of this, you will find many amortization loans being advertised as “payment option” mortgage loans, due to the fact that you are given an option in how you wish you pay. Even though the borrower is able to have flexibility in how they pay for their home loan, they are still subject to the true mortgage interest rate.
This results at the end of the first month actually owing more on your home mortgage than you did at the beginning of the month, and you pay increased interest on the difference until the mortgage is retired or paid off fully.
Short term lower monthly payments leads to short term gain. Lower payments make it easy to qualify for a mortgage loan. But it also leads to long-term financial pain. You end up with more debt on your original mortgage than you started with and greatly increased mortgage interest payments. The longer that you are in a negative amortization mortgage, the greater sum of money you will wind up paying on your mortgage.
There are times that a negative amortization mortgage makes good sense because of the easy mortgage qualifications and lower monthly mortgage payments. But this is true only in certain cases. If you run into financial trouble, or sudden and unexpected expenses you cannot avoid. Or you are laid off of work and can’t find a job right away, in such cases a negative amortization mortgage may make sense. Entering into a negative amortization mortgage due to necessity or with the knowledge down the road you will be on better footing financially is sometimes a positive choice. Once your situation changes you can arrange to make either additional or increased monthly mortgage payments to take up the slack. Or, if you have the money you might pay it all off at once.
Some people use the undemanding qualifications and lower payments to pay for a house while the value of the real estate increased. In such cases a person may choose to live inexpensively in a house while it appreciates in value, then sell later and realize a profit. The profit can then be used to pay off the mortgage. But if the property does not increase in value or appreciate then you may be saddled with a large expensive mortgage and no way to pay it off. Another valid use was for young couples to use the adjustable mortgage rate feature for easy qualification on tight income or budget. The appeal would be that as young workers their income was more likely to increase rapidly in the ensuing years and handling the negative amortization feature in order to buy the house was reasonable trade off.
There is the chance that, as in life, your financial situation may not improve on the time schedule you anticipated. When this happens you can be faced with some very tough decisions and possibly being forced to sell your home or property.
The mortgage calculators designed to evaluate adjustable rate mortgages can be very useful in analyzing the mortgage payments on a negative amortization home loan. In addition, the mortgage calculator can be very useful in viewing future mortgage rate changes and how they will impact the monthly mortgage payment as well as the total amount of negative amortization that will take place when the mortgage rate rises and the payment is capped.
It is a risky business, so think carefully before entering a negative amortization mortgage. It can be attractive to help cope with some situations, but it assumes a large amount of risk and should be avoided if possible. These home loans are available for both a home purchases and an existing mortgage refinance.