Have you ever wondered why mortgage lenders always have their mortgage payments due on the first of each month? Maybe you are buying a home and notice a cost on your loan estimate or closing disclosure called per diem interest. Questions come up like: What is that for, where did the figure come from, and do I have to pay for it?
In the mortgage world, per diem interest is most easily described as daily interest charged to a borrower for the use of money. In other words, every day a borrower owes money interest is charged. Early in the process, borrowers receive a loan estimate which breaks down details of the proposed loan. One of the main features of this disclosure includes stating the closing costs and pre-paid items. One of the pre-paid charges shown on the form is a daily interest charge. In just a bit, we show how easy it is to see what causes the amount to go higher or lower. Plus, there are helpful buyer strategies and the potential tax write-off involving mortgage per diem interest. Let’s dig in!
How Per Diem Interest & First Payment Dates Work
There is a direct relationship between a daily interest charge and the mortgage first payment due date. First of all, traditional mortgage lenders require a first of the month due date. Next, understanding per diem interest starts with knowing how interest is determined. To grasp the concept of mortgage interest, a rent vs. mortgage comparison probably works best. Paying rent on the first of the month pays ahead for the upcoming month. For instance, May 1 rent payment covers rent for May.
The opposite is true for mortgage interest because mortgage interest is paid in arrears. Making a May 1 payment pays for the interest which has accrued from the prior month. Make sense? Rent pays ahead, and mortgage interest is paid in arrears. Now, a simple example.
Per Diem Interest Example
For example, let’s set a closing date for April 27th, which makes the first payment due June 1. Using what we learned above, the June 1 payment covers the mortgage interest for May, but the borrower also had the loan for a partial month (April 27 – May 1). The borrower does not get a free pass for this period. Therefore, lenders charge per diem interest at closing to cover this partial month. In this example, there would be four days of daily interest charged to the borrower (28th, 29th, 30th, 1st for a total of 4 days). The dollar amount of interest per day would be multiplied times 4 in this case. Thus, the daily interest charge is pretty low in this example.
Conversely, loans closed early or mid month have a higher interest charge. For example, a buyer closing on April 10 would be charged 21 days of per diem interest. This is calculated by counting the days from April 11 through May 1. Sounds worse doesn’t it? Yes it is more interest paid, but the first payment is not due for 51 days!
So, each day the borrower owes a mortgage balance, interest is charged based on the rate, term, and balance. We mentioned how the mortgage payment is due on the first of the month, and it pays for the previous full month. Unless the closing is on the first of a month, the lender must calculate a partial month charge or credit of interest.
Is Mortgage Per Diem Interest Deductible?
Paying daily interest is the same as paying interest within a normal monthly mortgage payment. Interest is interest. So, for the first year’s calculation of total mortgage interest paid, your lender will add any per diem paid plus interest included in monthly payments paid. Mortgage lenders then report the full year’s interest paid to the IRS and the borrower on a 1098 Mortgage Interest Statement. Borrowers receive the statement every year there is a balance. So, make a note of the 1098 image here and expect it in January of each year.
Although, the next question is, “Can I write off mortgage interest paid?” Homeowners have traditionally enjoyed the ability to take a deduction for any mortgage interest paid. Assuming the taxpayer has enough deductions on Schedule A of the federal tax return to itemize. Every taxpayer receives a certain “standard deduction,” and the amount depends on several factors such as single, married, etc. Before 2018, many taxpayers took advantage of the mortgage interest deduction, but things changed in 2018!
2018 Tax Deductions Change
For 2018, taxpayers will notice a significant increase in the standard deductions. A higher standard deduction means potentially lower income taxes. In 2018, the standard deduction amounts increased too:
- Individuals $12,000
- Heads of household $18,000
- Married couples filing jointly & surviving spouses $24,000
Prior standard deductions were lower, so it was easier to itemize costs such as mortgage interest and property taxes. With the major standard deduction increase, mortgage interest along with other traditionally itemized deductions will not factor in many tax returns like the past. So, unless a taxpayer has sufficient mortgage interest and other itemized deductions, often the standard deduction is the higher amount. Thus, the taxpayer would choose the standard deduction for lowering the income tax liability.
In the end, many home buyers looking to buy a home for a tax write-off may not realize a tax benefit unless the homeowner has enough mortgage interest and other deductions to exceed the new higher standard deductions.
Home sellers also need to know the 2018 capital gains tax rules. Check out this article which explains how the IRS treats capital gains and the sale of a primary residence exclusion.
Keep in mind that this information is not tax advice and it is recommended to seek the advice of a tax professional for tax-related questions.