Can anyone point me towards general accounting principals, regulations, or agency guidance that governs how advance payments should be handled on mortgages? Specifically, I am looking for info on when a borrower pays multiple installments ahead on and ARM loan...how funds are applied, prepayment tracked, effect on future rate changes, etc. Any help would be appreciated.

This is loan contract issue and not a regulatory one. What do your notes say about prepayments?

That was my thought....but there are not provisions specifically in the note. This is simply the standard Fannie Mae ARM Note.

https://www.fanniemae.com/content/legal_form/3523.pdf

The relevant parts are 3(A) Time and Place of Payments and 6 Borrowers Right to Prepay but neither reference this situation at all. One could interpret that this means the borrower does not have any right/ability to make installment payments in advance (which would be just fine with me).

But, Fannie Mae Servicing Guide C-1.1-01 specifically says all payments made must be credited upon receipt and really doesn't provide for any other options. I feel like I am overthinking things here.

The note allows excess payments (more than the payment due in the current month) of PRINCIPAL, only. Future rate changes are controlled by the calendar, not by the payments received or balance due. When you arrive at a rate change date, payment adjustments are based on the outstanding principal balance, index plus margin (subject to caps), and number of remaining months until the originally scheduled maturity.

Many people who make prepayments of several month's payments are attempting to take mortgage interest deductions on their taxes this year rather than next for one reason or another. The problem with that is that IRS rules limit the taxpayer's ability to take interest credits early.

What we are running into are people who have made advanced installment payments, then they go through an ARM recalculation. For instance, if a borrower has "paid ahead" by 6 months then they have paid 6 installments at their current (pre-change) rate even though they would have had to pay a (potentially) higher rate had they made the payments as normal regular installments in the months following the change date.

This obviously has an effect on the interest income on the loan but it also complicates the change and new payment calculation quite a bit. I am just trying to figure out if we have other options. Thanks for everyone's help.

Are you saying that you post future payments today and split them into the principal and interest amounts indicated by an amortization schedule that was prepared when the loan was made (or at any other time in the past)? If so, you are not following the terms of your note.

Yes, this is how our system has always operated and your statement is exactly why I am questioning it. From my perspective, the Note doesn't really allow the payment of installments in advance. It provides for paying principal in advance but, rather unequivocally, requires a payment every month without exception.

With this said, I have noticed that the HUD handbook that details FHA mortgage servicing includes this in section 4000.1.III.A.1.e.iv. At first glance, it appears to require the servicer to allow the borrower to make partial prepayments and advance the installment due date and does not put any limits on how many times they can do this. What am I missing here?

"(A) Definition
A Partial Prepayment is a payment of part of the principal amount before the date on which the principal is due.

An Advance Full Monthly Payment is the payment of an amount larger than the full monthly payment, equaling an additional full monthly payment.

(B) Standard
The Mortgagee must apply Partial Prepayments as requested by the Borrower as either:

•advance full monthly payments; or
•additional payments toward reducing principal and future monthly payments.

In the event that the Borrower does not specify how the Partial Prepayment should be applied, the Mortgagee should communicate with the Borrower to determine the method of application or apply the payment in a manner previously communicated to the Borrower.

If the Borrower elects to have Partial Prepayments equal to a full monthly payment applied as an advance full monthly payment, the Mortgagee must allow the Borrower to skip an equal number of installments in the future without creating a mortgage Default or incurring a Late Charge."

The note form you linked above is not an FHA loan, right? If the loans in question are not FHA loans, how could HUD's FHA servicing guidelines apply?

Regardless of what a servicing guide says, it cannot supersede the borrower's rights and responsibilities spelled out in your note. Your note says (in relevant part):

6. BORROWER’S RIGHT TO PREPAY
I have the right to make payments of Principal at any time before they are due. A payment of Principal only is known as a “Prepayment.” When I make a Prepayment, I will tell the Note Holder in writing that I am doing so. I may not designate a payment as a Prepayment if I have not made all the monthly payments due under this Note.

I may make a full Prepayment or partial Prepayments without paying any Prepayment charge. The Note Holder will use my Prepayments to reduce the amount of Principal that I owe under this Note. However, the Note Holder may apply my Prepayment to the accrued and unpaid interest on the Prepayment amount before applying my Prepayment to reduce the Principal amount of this Note. If I make a partial Prepayment, there will be no changes in the due dates of my monthly payments unless the Note Holder agrees in writing to those changes. My partial Prepayment may reduce the amount of my monthly payments after the first Change Date following my partial Prepayment. However, any reduction due to my partial Prepayment may be offset by an interest rate increase.

The key to understanding this part of your note is the red sentence. By defining the word "Prepayment" to be nothing but principal, the note closes the door to any possibility that a "Prepayment" could be applied to future interest. The green sentence clearly intends that Prepayments MUST be used for no purpose other than a lump sum curtailment of the unpaid principal balance. The blue sentence seems to contradict the green standard, but when you read it carefully, you realize that can't be the case. The expression "accrued and unpaid interest" can only refer to the past--interest from past payment periods that was not paid when it was due. It seems, then, that the blue sentence is there to prevent borrowers from escaping the obligation to pay all interest when it accrues.

No matter how partial prepayments might affect the delinquency counter, delinquency has no effect on the accrual of interest. Interest accrual is based on the outstanding principal balance--regardless of the payment history that brought the principal balance to its current value.

Richard, I think the key is actually this sentence: "When I make a Prepayment, I will tell the Note Holder in writing that I am doing so".

Unless I tell them this is a prepayment, it stays a regular payment and will advance the due dates. This is very common on secondary market mortgage loans that have scheduled payments rather than those that are simple interest loans, which are much more common on bank portfolio loans.. Payments are applied to principal and interest as scheduled rather than on the day received.

The note is not the only contract document. FNMA/FHLMC have what most people would consider note terms in the mortgage or trust deed. If this loan uses standard FNMA/FHLMC docs, you also need to look at the mortgage or trust deed. This is from Section 2 of the FNMA note/mortgage for most states:

Application of Payments or Proceeds. Except as otherwise described in this Section 2, all payments accepted and applied by Lender shall be applied in the following order of priority: (a) interest due under the Note; (b) principal due under the Note; (c) amounts due under Section 3. Such payments shall be applied to each Periodic Payment in the order in which it became due. Any remaining amounts shall be applied first to late charges, second to any other amounts due under this Security Instrument, and then to reduce the principal balance of the Note.
If Lender receives a payment from Borrower for a delinquent Periodic Payment which includes a sufficient amount to pay any late charge due, the payment may be applied to the delinquent payment and the late charge. If more than one Periodic Payment is outstanding, Lender may apply any payment received from Borrower to the repayment of the Periodic Payments if, and to the extent that, each payment can be paid in full. To the extent that any excess exists after the payment is applied to the full payment of one or more Periodic Payments, such excess may be applied to any late charges due. Voluntary prepayments shall be applied first to any prepayment charges and then as described in the Note.
Any application of payments, insurance proceeds, or Miscellaneous Proceeds to principal due under the Note shall not extend or postpone the due date, or change the amount, of the Periodic Payments.

The first and last sentences of this section should be taken into account here.

Good points all...I think I agree with everyone. What are everyone's thoughts on this interpretation that takes into account a couple of the points being made.

As Richard and rlcarey point out, Prepayment is clearly defined in the Note as "a payment of principal only" and the borrower is required to tell the Note Holder in writing if this is what they are doing. If a payment is received and the Note holder is not told in writing that it is a Prepayment then we must look elsewhere for rights and obligations. With no other direct guidance available in the Note, rainman's section of the Mortgage would come into play. The key to this section is the heavy reliance on the word "due"....interest due, principal due, amounts due under section 3 (escrow). If the mortgage is current, then nothing is due and "any remaining amounts shall be applied first to late charges, second to any other amounts due under the Security Instrument, and then to reduce the principal balance of the Note."

I will also add that section 3 states that the borrower "will pay principal and interest by making a payment every month." There is no language that suggest that a borrower can skip payment in a given month because they made two in the prior month or because there are no amounts due. There is no wiggle room here from what I can see.

While advancing due dates seems to be relatively common, I am still struggling with how this is allowable.

Richard - The note I linked above is the standard FNMA form but it is exactly the same as the FHA model form. I simply linked one for simplicity. We service conventional, FHA and VA so my research on this has ranged all over.

Although your notes, servicing system, and business decisions may allow borrowers to pay mortgage interest in advance, as John observes, you will need to keep the records necessary to report accurate values to the IRS and borrower (form 1098).

H&R Block explains it to taxpayers this way:
Q. Can I deduct prepaid mortgage interest?
A.You might qualify for real estate tax deductions if you pay mortgage interest in advance for a period that goes beyond the end of the tax year. If so, you must spread this interest over the tax years to which it applies. You can deduct in each year only the interest that qualifies as home mortgage interest for that year.

Even for a fixed rate loan that's paying exactly as agreed, that's going to be tricky. The values that would appear on an amortization schedule prepared before a principal curtailment will all change as a result of the curtailment. If the loan is an ARM, that also adds the possibility that the interest rate and payment amount may also change during the period for which there was a prepayment.

If these tax reporting obligations plus the ARM adjustment problems you cited earlier in this thread are too much trouble and expense, then you want to read the note in such a way that prohibits prepayment of interest. When the possibility of prepaid interest is taken off the table, then any payment above and beyond fees outstanding and interest already accrued must go to principal. Whether that excess is handled as a curtailment or as prepayment of future installments of principal makes no difference when you hit a rate/payment change date. The only thing affected is the due date/delinquency counter.