Unlike most loans, mortgage principal and interest are paid in arrears. This means that when you make your payment on the first of a month – all contemporary mortgage loans are written as of the first of the month – you are paying the previous month's interest. Over the long-term, this difference means little. However, at the beginning or the end of the mortgage, it may be significant.
Accrued Mortgage Interest
When you buy or refinance a home, the interest in arrears feature affects you. If you close at any time other than the first or last day of a month, you'll owe some accrued interest. Since all mortgage loans are due on the first day of a month, closing your loan during a month means you'll owe interest from closing day through the rest of the current month.
But don't worry. It doesn't cost you any extra interest, but it can increase the amount of cash you need for closing.
First Mortgage Payment
Your first mortgage payment is not due until the first of the month after the first month of your new mortgage. For example, you close your new mortgage loan on the 18th of month A. Your first monthly payment is not due until the beginning of month C, bypassing the initial month of your loan, month B. Therefore, closing a new mortgage on the 18th of May means your first payment is not due until July 1.
Last Monthly Payment
When you have sold your home or refinance it, the interest in arrears feature may be less attractive. If you close your sale or refinance on the 18th, your mortgage payoff will be higher than your apparent outstanding balance. Since you pay interest in arrears, on the 18th you will owe your balance at the beginning of the month plus accrued interest through the closing date. While not a penalty, this will reduce your cash, if a sale, or add to your new mortgage balance, if a refinance.
The Significance Over Time
While mortgage accounting differs from most other loan types, it has little long-term significance. However, making payments in arrears does affect you positively at the beginning and negatively at the end of your mortgage loan. The net significance or effect is zero.
You eventually pay all of the interest due – neither more nor less. At the closing of a new mortgage loan, however, you must be aware that you'll need sufficient cash to complete the purchase or understand that your new mortgage balance may be a bit higher than you thought with a refinance.
