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Mortgage Basics: Prepaid Interest and Escrow Accounts

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Prepaid Interest BasicsMany find it difficult to understand the concept of ‘escrow’ in general. We shall try to make that clearer here. First, however, the question of prepaid interest.

Mortgage Questions: What is Prepaid Interest?

In mortgage terminology, prepaid interest relates to an advance payment made to cover the interest due for the remaining days of the month in which the mortgage is closed. As an example, let’s say you closed your mortgage loan on 16th April. On that date you would prepay the interest due on your loan for the rest of April.

Whether mortgage closure was on the 1st April or the 29th, the prepaid interest would cover the interest due for April. 30 days interest on the loan in one case and 2 days in the second. Future interest would be paid in arrears.  Thus, you would pay May’s interest on June 1st and so on.

The reason for this lies in the way that mortgage loans are amortized. If there are more than 31 days interest due when the first mortgage payment is made, problems can arise in amortization calculations.

The  ‘ The Real Estate Settlement and Procedures Act’ brought with it ‘Truth in Lending’ and ‘Good Faith Estimate’ – it could not be met with the possibility of variable interest owing. To cut a long calculation short, the solution was prepaid interest, so that no mortgage interest due could be more than 31 days in arrears.

Question: What is an Escrow Account?

We get many mortgage questions about escrow accounts. When you take a mortgage you have payments to make in addition to your principal and interest commitments. You also have insurance and taxes to pay. Rather than relying on you to make the lump sum payments when they become due, the lender adds 1/12 of these payments to your monthly mortgage repayment. This is deposited into an escrow account.

An escrow account is one administered by a third party, and that cannot be used until certain contractual obligations have been satisfied by each of the original two parties. It is a way for the lender to make sure that the insurances and taxes are paid by the mortgagee. It is a common agreement in the USA and is usually written into the mortgage agreement. The escrow account is established by your lender, who pays into it the tax and insurance portion of your monthly payment.

How Much Money Can the Lender Deposit into an Escrow Account?

Many mortgage questions also relate to the sum  of money that lenders can deposit into an escrow account.  Your mortgage lender should total the annual sum of taxes and insurance premiums.  A sum no greater than one-twelfth of that can then be deposited into an escrow account – PLUS a contingency cushion. This cushion should be no more than is needed to avoid overdrawing the escrow account should taxes or insurance premiums be increased.

These conditions will be detailed in the mortgage agreement document. Conventional mortgages, not administered by FHA or VA, can waive the requirement for an escrow account if the equity on the property is at least 20% of its value.

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