For ARM loans, must odd days interest be prepaid?

Not unless it's required by your state law (very unlikely), an investor (likely), or some other interested party (insurer, guarantor, etc.) What do you have in mind?

These are in-house portfolio loans. I don't think its required by state law since this FI has never collected it upfront on balloon loans. We were trying to determine if ARMs had this requirement.

The credit dept. was telling me that the first principal and interest payment will be applied so that the interest paid is the interest accrued for however many days to the first payment due date. I guess this is how it is amortized.

Is this how it works, collect upfront or collect in the first payment?

The big "IF" that still remains is whether or not the billing routine for your mortgages can accomplish that. Usually, the first several payments on a mortgage loan are barely more than the amount of interest for the month. If you have 25 odd days interest added to the interest for the normal first month's payment, you're going to run into problems unless you increase that first payment.

Another approach might be to do an interest-only payment for short month (odd days). But wouldn't that introduce an interest-only payment into the mix?

The cleanest way to do this is to collect long-odd-day interest at closing and to add a month to the first payment period of loans that would otherwise have short-odd-days in the first payment. That way all your loans fit nicely into a monthly-simple-interest amortization schedule. Also, you avoid changes to the basic payment schedule that can frustrate APR calculations and potentially cause negative amortization or interest-only payments.

I guess I'll have to have them demonstrate for me how the system works.

And that's the reason that collecting it at closing in the form of a prepaid FC is the overwhelming practice of the industry when they want payments to always be due on a specified day of the month (typically the 1st).

Just make sure that if you have any prepaid interest credits for short months (loan closing less than 1 month before first payment date) that you DO NOT include them in the prepaid finance charge.

The credit should be reflected in the overall finance charge to offset the extra days interest collected in the first payment, but may not be used as a credit to offset prepaids.

Looking for regulatory backup for this position? Check the definitions at 1026.2(a)(23):
Prepaid finance charge means any finance charge paid separately in cash or by check before or at consummation of a transaction, or withheld from the proceeds of the credit at any time.

A credit is neither paid by cash or check, nor withheld from proceeds of credit.

I agree.

I don't agree.

There's no such thing as a "negative Finance Charge." Since the inception of BOL, we've had many discussions of this topic. This thread is an example. Usually, the credit involves points, but the same analysis holds true for refunds of any type of fee or charge. You can't call something a "Finance Charge" or "Prepaid Finance Charge" if it isn't a "charge" to begin with.

Richard,

I disagree with your disagreement!

Generally an interest credit is used to offset unearned interest included in the first loan payment - the first payment may include 30 days interest even though the loan closed only 25 days earlier, so the five days of unearned interest included in the first payment is offset by the interest credit. While it is not a prepaid finance charge, it does reduce the amount of interest that must be included in the final finance charge.

If the interest credit is not included in the interest component of the total finance charge, you are incorrectly disclosing the total cost of credit to the borrower.

Mathematically and as a business practice, I agree with your analysis and explanation of this practice...but we're discussing Reg. Z, not generalities. The regulation speaks only in terms of "charges", i.e. receivables. An interest credit transaction creates a payable, not a receivable. If you can't call it a charge then there's no way it can meet Section 1026.4's definition of a "Finance Charge." Reg. Z's authors could recognize this practice and authorize deductions from the Finance Charge, but they have not done so.

Just because it's not correct to net credits against charges, that doesn't mean the credits must disappear from the TIL disclosure. Since a credit is a disbursement to the borrower, it fits very nicely in the Amount Financed with all the other cash-out items. Although this reclassification of the credit increases the FC, it also increases the Amount Financed and that totally neutralizes the effect on the APR.

I may be mixing the two topics. Does it matter if the interest is calculated on an actual/365 and not the usual 30/360 accrual method for calculating mortgage payments?

All interest should be calculated in the manner prescribed in the note. Calculating per diem interest using actual days and a 365 basis is more favorable to the borrower than using actual days and a 360 basis, so borrowers won't complain about that method--even if it contradicts the note.

As a matter of "housekeeping", it's not the best practice to use old threads for new or different discussions. You're more likely to attract participants with a fresh thread that requires only a quick read. By the time you wade through a few thousand of them, you'll agree that these evergreen monster threads are hard on readers. If you want to pick up on the general topic but start in a new direction, reference the old thread with a link and then start your new discussion in a new thread.