You may have heard this before. That when you refinance you get to skip two payments. In fact, it’s not uncommon to hear a lender actually promote this notion. If so, I think it’s a bit misleading. There’s no such thing as skipping payments during a refinance, the payments are made just in a different manner.
First, it’s important to understand that mortgage interest is paid in arrears. That means each month when you make a mortgage payment, you’re actually paying for the time you owned the property from the previous month. Arrears simply means ‘backwards’ in a sense. But that’s exactly how mortgage interest is handled.
Second, let’s consider prepaid interest. You probably don’t remember this from your initial closing, but you might. If you don’t remember, get a copy of the settlement statement you signed at your closing when you first bought and financed the home. You will see the term “interest” as a line item along with a number of days listed. The number of days listed is the number of days up until the first of the following month. If you closed on the 20th, the lender collected 10 days of interest at closing. This is in effect your very first mortgage payment, you just paid it ahead of time.
The same thing happens when you refinance. Depending upon when your loan closes and funds, there will also be a line item for interest charges. But here is where the “skip two payments” thing comes in to play.
When the lender prepares to refinance an existing mortgage, one of the first things done is to order a final loan payoff from the current mortgage company. The loan payoff will include the outstanding principal balance plus interest that has accrued for the current month. Remember, mortgage interest is paid in arrears and when the payoff is ordered the mortgage payment has yet to be made for that month.
When your lender gets ready for your closing, there will be a payoff to the old lender and prepaid interest to the new lender. Let’s again assume you’re going to fund on the 20th of the month, retiring your old mortgage. The payoff amount will be the loan balance plus 20 days of accrued interest. Next, you’ll provide 10 days of prepaid interest to your new lender at the same closing, for a total of 30 days. This of course assumes you haven’t made the current mortgage payment because you knew you were going to refinance. If on the other hand you made the payment on the 5th of the month, there will be five days of accrued interest collected and 25 days of interest to be sent to the new lender. The process works the same no matter which day of the month you close.
Because you had yet to make the monthly mortgage payment and the accrued interest is included in the loan payoff while at the same time collecting prepaid interest to the first of the following month, in effect you did skip two payments, yet you really did pay it, just in a different manner. What essentially happened is you rolled your mortgage payment into the new loan. The payment included old and new interest. It certainly feels like you skipped a couple of payments when in fact you just put them into the new loan. Note, it’s completely your option to make the interest payments out of pocket and not roll them into the loan, the option is completely up to you.
Finally, with accrued and prepaid interest, is there a better time of the month to close, assuming the new rate will be lower than the old? When refinancing into a lower rate, it makes sense to grab that low rate sooner rather than later. Closing on a refinance in the early part of the month means you’ll be paying less interest overall because the new rate takes effect early on. I can go over these scenarios with you and show you exactly what your situation would look like, but if you’ve heard the term “skipping payments” just take it with a grain of salt.