May 10th, 2019 11:23 AM by Jackie A. Graves, President
You might have heard this at some point in the past, either from
a mortgage loan officer or perhaps some sort of mortgage marketing campaign.
When you refinance a loan you actually skip your next payment and you’re
essentially mortgage payment free for that month. But that’s not actually true.
Mortgage interest is paid in arrears. That means that on the
first of every month when the mortgage payment is due, an amount goes directly
to the outstanding principal balance and the remaining goes toward interest
paid for the previous month. If last month had 31 days, the mortgage payment
would include an amount to pay for accrued interest over the 31 day period.
Contrast this with prepaid interest. Prepaid interest is
collected on all new mortgage loans whether the note is used to finance the
purchase of a home or when refinancing. You may or may not remember but when
you closed on your first mortgage the new lender collected prepaid interest
depending upon the day of your closing.
If for example you closed and funded on the 20th of the month,
the new lender would collect prepaid daily interest up to the first of the
following month. In this example, 10 days of interest was collected. If you
closed on the last day of the month, just one day of interest is collected.
This by the way is why buyers are encouraged to close toward the end of the
month to save on the amount of prepaid interest needing to be paid at the
settlement table. Because you prepaid this interest, there is no separate
mortgage payment needed on the first of the following month.
When refinancing there is both interest in arrears and prepaid
interest involved. When a mortgage company accepts an application to refinance
an existing loan, one of the first acts the lender will perform is to order a
payoff amount from the current mortgage company. The payoff amount is the total
amount needed to completely retire the previous mortgage. This amount includes
both the outstanding loan balance and accrued interest that has yet to be paid.
If the closing takes place on the 20th, the payoff amount would
include the outstanding principal balance, 20 days of accrued interest and 10
days of prepaid interest up to the first of the following month. Because this
prepaid interest is typically rolled into the loan amount, there is no mortgage
payment needed for the following month. This is where the phrase “skip a
payment” comes into play. But that phrase is false. There is in fact a payment
it’s just rolled into the loan amount. Borrowers can elect to pay the prepaid
interest out of pocket instead of adding it to the new loan but that’s somewhat
rare. Yes, the loan amount is increased but really by a very small amount and
the monthly payment is only marginally affected.
When you hear of a loan officer explaining how someone can skip
a mortgage payment when refinancing, that’s really not true. There is a payment
made- it’s just included in the new mortgage.
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