WRITTEN BY DAVID REED
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.