I read the musings of a brilliant but young mortgage man that he was having trouble explaining pre-paid interest, which is line 901 on the Good Faith Estimate form. I discuss this in my book "Get The Money / A Consumers Guide To A Successful Mortgage Application" but let me try a different approach here.

If you ask the consumer if mortgage interest is paid in advance or in the arrears (after you've used the money) the majority would say in advance and point to the pre-paid interest on the Good Faith Estimate or HUD-1. If you asked the same question of a group of traditional bankers they'd be split about equally! The truth is that all mortgage interest is paid in the arrears!

But, what about that Pre-Paid Interest? Pre-Paid means in advance!

Before, I address this lets look at a little history. When our parents and/or grandparents bought a house the first mortgage payment was due on the same day of the next month. This was convenient for the banks because over time they had a near equal number of payments due each day of the month. This made it easy for the bank, 50 full time bookkeepers in the basement could keep track of all the loans, had all of the loans been due on the first of the month then they would have needed 200 people, but for only the first week of each month.

Then came computers, suddenly there was a better way! In the late sixties banks started making all loans due on the first of the month. It was wonderful! Suddenly bankers knew exactly what each department and each account was doing everyday, even thought it was 3 days behind. This was much better than the old system where the bookkeepers reports told them where they were on one day last month.

The bank soon discovered a new problem, it took several weeks to get a new loan into the system! To allow the remaining bookkeepers and their new assistants, the keypunch operators time to get the new loans into the system the first payments were now made due on the first of the second month fallowing the loan closing.

Change is normally for the good and this one was, but it often brings new problems. The new problem with loans due on the first of each month, but loans closing and more importantly funding (interest accrues from the date of funding a loan) on everyday of the month, was that often there was not sufficient money to pay the accrued (earned) interest when the payment was made. Lets look at the numbers.

I'm going to use a $100,000.00 loan at 6.500% for 30 years, with a principal and interest payment of $632.07.

The daily interest cost on the full $100,000.00 is $17.81.

If we divided the $632.07 by the daily cost of $17.81 we discover that it only pays for 35.5 days! So if the closing/funding is more that 35 days before the first payment the loan will not start amortizing (amortizing is the systematic repayment of a loan) even if the buyer makes all his payments on time he's still going to have a balance 360 months later! This problem gets worst as the days to the first payment go over 30, and they could go as high as 61 days.

The solution to this problem was for the lender to collect a one time pre-payment of interest at closing sufficient so that there is never more than 31 days interest due when the first payment is paid. This solved the problem when the buyer makes his 360 payment (adjusted for the pennies that had to be rounded off each month) his loan is paid in full!

Then along comes RESPA, The Real Estate Settlement And Procedures Act and with it the "Good Faith Estimate" and "Truth in Lending" forms. At the time this came out many lenders doing consumer loans were still writing "Prepaid Interest loans" these nasty loans added the interest to the principal and that was your balance. If you got $,1000.00 for 3 years at 21% the loan balance would be about $1,310.76 and each mount you would pay$36.41 and the balance would be lowered by the full $36.41. (Please don't call me on these numbers, it's been since 1970 since I've seen one of these beasts.) So HUD included Pre-Paid Interest in the calculation of the APR, even though I've never seen a mortgage written this way. Because this is still in the APR many lender will only show 1 days pre-paid interest on their original "Good Faith Estimate" this is legal but depictive.

Honest lenders will show 15 to 30 days pre-paid interest on their "Good Faith Estimates" because they can't possible be sure when the loan will be funded! Showing one days interest of $17.81 keeps the APR lower, and falsely shows the dollars need to close lower than showing 30 days interest of $534.30! That $516.49 difference can really hurt and surprise the home buyer at closing! In my market with a more typical $350,000.00 loan that's could be as much as $1,807.72 in unanticipated closing cost. Non-conforming buyers had best have an EMT standing by.

Personally I recommend disclosing 25 days pre-paid interest because if a loan is closing in the first week of the month we can normally get a credit as opposed to a charge and have the payment come due on the first of the very next month. I don't want the buyer being shocked and needing extra money at closing.

Bill

William J Archambault Jr

The Real Estate Investment Institute

http://www.reii.org