Article courtesy of MCAP.
The best way to understand the concept of interest adjustment is to start with knowing and understanding the term “Interest Adjustment Date” or IAD. Every fixed rate mortgage has an IAD and the name implies that this is the date upon which an interest adjustment will take place but that’s not really what it is.
The Interest Adjustment Date represents the beginning of the amortization period. For a mortgage with an amortization of 25 years, for example, it will be fully repaid exactly 25 years from the Interest Adjustment Date. It also represents the date upon which semi-annual compound interest calculations begin. Think of it as the “starting line” in a race. Many mortgage advances (closings) take place before the IAD – in some cases, close to a full month before the IAD. The Interest Adjustment applies to this period between the advance date and the Interest Adjustment Date.
Let’s consider an example: Our borrower, Barry, is closing the purchase of his new house on January 10th and to do this, he is borrowing $200,000 at 6% for a five year term based on a 25 year amortization. He will make his mortgage payments monthly on the first of each month. Because he has chosen to pay monthly on the first of each month, Barry’s 25 year amortization period will actually begin on the next “first day of the month” – in this case, February 1st. Unlike renting, where rent is paid in advance (tenants pay for the month of January on January 1st), mortgage payments are made in arrears – or for the period which has just passed. Barry will therefore make his first mortgage payment (with blended principal and interest) on March 1st for the month of February. That payment will reduce his principal balance as will all future payments, until his mortgage is fully paid exactly 25 years later.
But Barry’s mortgage company will advance the funds to him on January 10th – or 21 days before his Interest Adjustment Date. Will Barry receive the benefit of having the funds for three weeks without having to pay interest in exchange for the benefit of having the funds? Obviously, the answer is no. He will have to pay interest at 6% on the money he borrowed for this 21 day period. The amount will be $690.41 and this will cover the period required to get Barry up to the “starting line” of his 25 amortization – or his IAD which is February 1st. He will pay only interest during this period to compensate his lender for the use of the money. The interest which Barry will pay during this period is known as an Interest Adjustment. For Barry, it will be like having an interest only mortgage for a period of three weeks. He will have an amortizing mortgage after February 1st.
Depending on which lender Barry has chosen to deal with, there are three possible ways for his Interest Adjustment to be paid. Different lenders have different policies on how Barry would be required to pay the $690 he will owe:
- Barry could pay the Interest Adjustment to his lender on closing – either by making the payment directly to his lender or by way of the lender deducting the Interest Adjustment from the mortgage advance. If it is deducted from the advance, his lender would only advance $199,310 and Barry would make his first mortgage regular payment on March 1st. Since the amount he is receiving from his lender is less than the face amount of his mortgage, Barry will have to ensure that he has enough to cover the balance due on closing for his house purchase. He may have to simply provide the $690 himself anyway.
- The Interest Adjustment of $690 could be added, as a one-time adjustment, to his first regular mortgage payment on March 1st. Barry’s lender may only allow this option if the Interest Adjustment is very small as they will not receive it until a month after it is really due.
- Barry’s lender could require him to make a one-time interest payment of $690 on February 1st. This could be by automatic withdrawal from the bank account Barry chooses to make his future mortgage payments or by way of a manual cheque.
