We started this discussion on how to get a lower interest rate without refinancing your home loan … or any loan for that matter. Last week, we defined Effective Rate of Interest. To see part one of the blog, click here.
This week, we’re going to start focusing on the secrets to reducing your effective interest rate.
When refinancing a home, banks will often advertise that you’ll get to skip 2 months of your house payment. What that means is that you are deferring your house payment until the end. Here is how that works.
Let’s say you close your refinance loan today, September 10th, 2014. In order to skip two months, the lender refinancing the house will have let you know they are closing the loan that month and there is no need to make a September house payment because the loan being refinanced will be paid in full. Also, when closing a loan in the middle of a month the Settlement Statement (or HUD 1) will have prepaid interest from the day the loan Funds through the end of that month (FYI. That is the only time lenders are permitted to charge interest prior to its accrual).
Look at it this way; when you pay rent for an apartment on the 1st of the month, you’re paying for the right to live there for the entire month, right? Mortgages aren’t quite that simple. When you make a payment on the 1st of the month, you’re paying for the accrued interest from the prior month, plus principle (depending on the type of loan, of course). This is where the expression, “Mortgages are paid in arrears, “was born. Now, and because of this, going back to our example of closing September 10th, 2014 your first payment will be due on the new loan November 1st, 2014.
So, get this – if you went ahead and PAID the October payment on the new loan instead of skipping it, your entire payment would be applied to the principle balance. Interest is only charged on outstanding principle balance. Because mortgages are paid in arrears, and the interest for the refinanced loan has not been charged yet, your entire payment will be applied to the actual amount you owe on the loan (the principle balance). By doing this, you will save yourself almost 6 months of payments in interest because your principle balance has been impacted, which means they have less balance from which to apply the interest on your loan.
Need a visual? Check out this example:
Yes, this example applies to new loans (or newly refinanced loans). We have other ways to help you lower your effective interest rate, even without refinancing. Next week, we’ll let you in on another secret, so stick around for part three on this topic.
Questions? Please ask!