You may think your mortgage lender is being benevolent after you close on your new home by giving you a reprieve on mortgage payments, but that’s not the case. Because of the way lenders calculate interest, you always pay your mortgage in arrears. This means that once you sign on the dotted line, you could go for a full month or more before you need to write that first check.
When you take out a mortgage to purchase a piece of real estate, your lender uses amortization to calculate your monthly payments. Most mortgages require monthly payments. Before a payment becomes due, the lender looks at the original loan balance after the last payment and calculates the amount of interest owed for the month as well as the amount applied toward principal. This process continues until you pay off the loan.
Payment In Arrears
Most loans, rentals, installment agreements and leases have you pay ahead. Since lenders calculate mortgage payments using the principal balance as a base, they cannot accurately calculate interest until the month has ended. As you would make a rental payment to cover the month of April on the first of the month, you would not pay an April mortgage payment until May, or the following month.
Because you pay mortgage payments in arrears, the lag in time before a first mortgage payment becomes due surprises many new homeowners. When you close on your mortgage, the lender includes the first mortgage payment in the closing costs as prepaid interest. If your closing takes place on January 2nd, interest accrued from that date until the end of the month is included in the closing costs and prepaid. As you pay your mortgage in arrears, you would pay your February payment on March 1, giving you close to two months before you have to write a check.
Mortgages lenders often offer borrowers choices when taking out a mortgage, and one type allows you to pay even more in arrears than normal. Adjustable-rate mortgages, or ARMs, allow your mortgage rate to fluctuate throughout the life of the loan. One type of ARM puts you on a limited or minimum payment schedule where your monthly payment does not apply toward principal and doesn't even cover the entire amount of accrued interest. Lenders apply the interest in arrears to your principal, substantially increasing the amount you owe. These types of mortgages present significant risks, with Bloomberg BusinessWeek rightly deeming them “nightmare mortgages.”
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