WASHINGTON — Can you be charged interest on your mortgage even after you've fully paid it off? Can the meter keep running when you owe the bank nothing — your principal balance is zero?
Surprise! Much to the chagrin of large numbers of home sellers and refinancers, the answer for years has been yes. If your loan was insured by the Federal Housing Administration and you paid it off before maturity, at closing you'd be expected to cough up a full month's interest, no matter what day of the month you actually settled.
Even if you closed on March 2, for instance, you'd be charged interest by your loan servicer through March 31, potentially adding hundreds of dollars to your costs in the transaction. The FHA's practice has been unique among major players in the housing finance marketplace. Fannie Mae, Freddie Mac and the Department of Veterans Affairs all require interest to be collected only to the day of principal payoff. After that, the meter stops.
But change is on the horizon. Thanks to a regulatory mandate from the Consumer Financial Protection Bureau, the FHA has agreed to end its controversial full-month interest policy, but only for future borrowers. The FHA has until Jan. 21 to make the switch, so sellers and refinancers who currently have FHA-insured mortgages are cut out of the deal. Many will still get hit with extra interest charges.
Here's a quick overview of what's behind the agency's belated retreat. For the last decade, homeowners and realty brokers have complained that the FHA's interest payment policy amounts to gouging. Not only were many sellers unaware of the FHA's odd requirement, but they didn't factor the extra costs into their financial plans.
The National Assn. of Realtors, which began publicly criticizing the practice in 2004, said that by insisting on full months of interest payments, the FHA effectively has been squeezing tens of millions of dollars in unjustifiable extra charges out of sellers. In one year alone, 2003, according to the association, FHA borrowers paid an estimated $587.4 million in "excess interest fees."
In 2011, complaints from constituents prompted Sen. Ben Cardin (D-Md.) to introduce legislation that would have banned full-month interest charges and required FHA loan servicers to compute payoffs on a per-diem basis.
Cardin's bill ultimately went nowhere. The FHA brushed off its critics, arguing that by guaranteeing bond investors a full month's interest on mortgages, its interest rates were slightly lower than its competitors' rates. One mortgage industry estimate put the rate break at roughly 0.10% to 0.15%.
Real estate industry experts, however, said the true beneficiaries of the long-standing practice were loan servicers, who could earn interest on the "float" — the money they collected from borrowers and had free use of until the end of the month, when they had to disburse final interest payments to bond investors.
But financial system overhaul legislation passed by Congress in 2010 — the Dodd-Frank Wall Street Reform and Consumer Protection Act — got in the way of this game. The law empowered the new consumer bureau to write regulations banning prepayment penalties. Under the rule the bureau adopted, the FHA's full-month interest policy amounted to such a penalty — essentially a fine on borrowers who couldn't or didn't pay off at the end of the month. Since home buyers rather than sellers typically schedule closing dates, many sellers were unable to control the exact date their FHA loans were paid off — leading to hefty interest penalties under the consumer bureau's definition.
Tucked away in a Federal Register notice announcing its plan to change the policy, the FHA finally came clean on whether the tiny interest break that borrowers received was ever worth the extra interest amounts they could face if they prepaid the loan. New borrowers next year "can expect to pay a slightly higher rate," the agency said, "but they would also receive full benefit from lower interest costs [at closing] when they prepay ... in most cases more than offsetting the cost of the higher rate."
Aha! So in fact under the old practice, the FHA's customers paid more than they should. And presumably some of the estimated 7.8 million existing FHA mortgage borrowers who are not covered by the forthcoming policy change will continue to be vulnerable to paying more than they should.
The only way around it: If you are a seller or refinancer paying off an FHA loan, insist that your closing is at the end of the month, not the beginning.