If this seems odd to you, it’s important to understand two important factors about mortgages: the interest is paid in arrears, and the principal is paid in advance. Let’s take a closer look at what those things mean.
Mortgage Interest Is Paid in Arrears
Mortgage interest is paid in arrears, which means after it’s accrued, not before. Interest on your mortgage begins accruing at closing and doesn’t stop until the loan is satisfied in full. You’ll prepay interest for the month in which you close at closing. If you close in March, the interest accrued for the portion of March during which you own the house will be prepaid at closing. If you close March 15, you’ll be charged prorated daily interest from March 15 through March 31. If you close March 1, you’ll prepay interest for the entire month. If you close March 30, you’ll prepay interest for March 30 to March 31. Interest continues to accrue in April, the first full month after the month in which you closed. Therefore if you close March 15, and you’ve prepaid interest for March, the interest that accrues in April gets paid in your first full mortgage payment, due May 1.
Principal Is Paid in Advance
A mortgage payment consists of two main parts: interest and principal. (We won’t cover taxes and insurance here, which are also included in your mortgage payment for escrow.) The principal portion of your mortgage payment is paid in advance, for the following month. Each principal payment reduces the balance you owe. You’ll pay interest on a lesser balance in the ensuing month. The first mortgage payment that you pay on May 1 in this example not only contains the interest owed for April but also the principal owed for May.
Let’s Do the Math
Suppose you borrow $200,000 at 5% interest. Your monthly payment would be $1,073.64, payable in equal monthly installments for 30 years. You can calculate your daily interest for the period of time prior to 30 days before the first payment is figured, by taking $200,000 times the interest rate of 5%, which is $10,000. Next, divide that number by 12 months and get $833; divide the result again by 30 days to get $27.78. Your daily interest rate works out to $27.78. You’ll owe 16 days of interest for March, or $444.48, which you would pay at closing if you were to close on March 15. You’ll make a mortgage payment of $1,073.64 on May 1. That payment will pay the interest for April: $1,073.64 less $833.33 (a full month’s interest for April) equals $240.31, which is representative of the reduction in principal. Your unpaid principal mortgage balance as of May 1 is $199,759.69, subtracting $240.31 from $200,000. To calculate the rest of your mortgage payments, you can use our mortgage calculator:
The Bottom Line
You can avoid paying all that prorated interest out of pocket at closing if you close as near to the end of the month as possible. You’ll have a long hiatus before that payment comes due if you close at the beginning of the month, but you’d have to make a fairly substantial interest payment for that month’s interest at closing. You’ll most likely welcome some breathing room between closing and the due date of your first mortgage payment, given the large sum of money you’ll pay at the closing. But you’re not actually skipping any payments. While it might seem like you’re getting a month free of a housing payment, you really aren’t.
