In the United States, loan payments include interest for the previous month. Regardless of what type of loan you have, whether a car loan, personal loan or mortgage, payments are not required until interest has accrued. Mortgage lenders charge interest based on the balance of the loan at the end of the previous month, not the beginning of the current month.
Most loans calculate an interest annually. This means that if your interest rate is 6 percent, you will pay 6 percent of the balance of the loan each year as interest to the bank. If you borrow $10,000 from the bank with a 6 percent annual rate and do not pay back any principal on the loan, you would owe the bank $600 in interest over the year. Each month you would owe the bank $50 in interest as part of your monthly payment. If you only pay the $50 on each loan, the balance on your loan will stay the same.
Most loans are amortized over a certain number of years. The most popular mortgages amortize over 30 years. This means that at the end of the 30 years when all payments have been received, the loan should no longer have a balance. Since the interest is based on the balance of the loan, 6 percent in year one is more than 6 percent on year 15 on a 30-year mortgage. The fixed payment each month must reflect the decline in principal and the corresponding declining interest owed each month. This is why most of the interest is paid at the beginning of a loan and not the end because the balance is bigger at the beginning of a loan than the end of the loan.
Interest in Arrears
First mortgages require payment on the first of each month. Since most mortgages close in the middle of the month, interest must be prepaid at the time of closing between the date of closing and the end of the month. This is to ensure that the first full payment that is required is for a full month’s interest. When you close your mortgage, you will see a section labeled prepaid interest. This will have the daily interest times the number of days remaining between the funding date and the last day of the month. This is why it feels like you get to skip a payment when you refinance your home. If you refinance on December 15, your first mortgage payment is not due until February 1. The closing costs already include the interest owed on the new mortgage from December 15 through December 31 that would normally be paid in January.
Making extra principal payments each month on a 30-year mortgage can lower your overall mortgage term significantly. One extra payment a year can lower the mortgage terms by five to seven years. This is due to the minimum monthly payment staying the same, but the amount of interest owed being lower because of the lower than anticipated principal balance.