Per Diem: What it is, How it Works, Examples

What Is Per Diem Interest?

The term per diem interest refers to the interest charged on a loan on a daily basis—most often on mortgages. Part of the administrative process, this kind of interest is calculated between the closing date of the loan and the time at which the mortgage loan actually begins. Per diem interest charges may be incurred if a borrower receives their principal payment and begins the loan repayment period on a day other than the first of the month.

How Per Diem Interest Works

Per diem interest is part of the loan administration process. It allows for convenience and flexibility in the disbursement of a loan. Since not all loans close at the end of the month, lenders charge per diem interest to cover the period between the time a loan is closed and the day before repayment begins. As mentioned above, the repayment date is normally the first of the month. So even though the full terms of the loan may not be in effect right away, per diem interest allows the lender to be compensated for the work it's done to fund a loan before it's actually repaid.

For example, if a loan closes on June 15 but the lender requires repayment on a mortgage for the first of the month, they charge the borrower per diem interest between the 15th and June 30. Repayment, including regular principal and interest payments, officially begins on July 1.

Borrowers must take per diem interest into account when they consider closing a loan. When a mortgage payment's due date is the first of the month, per diem interest comes into effect. The interest charge covers the total number of days leading up to the first full monthly payment cycle. Lenders have some latitude in how they structure per diem interest payments and may or may not begin amortizing the loan at the time of distribution.

To calculate how much a borrower owes in per diem interest, the lender may use a daily interest rate to determine a borrower’s daily interest. The lender can then multiply the daily interest by the number of days in the per diem interest period.

Special Considerations

There are a few things borrowers must consider when it comes to per diem interest. First, different lenders may have different policies when it comes to how they charge per diem interest on their mortgage and loan products—some don't even charge it at all. It's always best to check with them to see which one applies. For instance:

• Some lenders accommodate borrowers by starting a monthly repayment cycle on the day that a loan is issued. In these cases, per diem interest usually doesn't apply.
• Lenders that require borrowers to make payments on the first day of the month usually calculate per diem interest for the days leading up to the beginning of the first payment cycle.
• There are lenders that allow borrowers to make a partial per diem interest payment on the first day of the subsequent month after a loan has closed and the principal has been issued.

Another major consideration that borrowers must account for is compounding. Virtually all lenders charge interest on a compound—rather than a simple—basis. This means any unpaid interest is added to the principal value of the loan. Interest accumulates on this (new) amount, which means the amount owed increases.

Example of Per Diem Interest

Take a borrower who is approved for a $100,000 mortgage loan with a fixed interest rate of 4.75% for 30 years. The lender requires that payments begin on the first day of the month following a full month’s repayment cycle. The borrower’s loan closes and the principal is distributed on July 29—three days before the first day of the next month. The borrower is required to pay the lender per diem interest at the time of the principal distribution.

Using a daily interest rate of 0.013% (0.0475 ÷ 365), the borrower must pay the lender $39 (0.00013 x $100,000 x 3) in per diem interest. A lender can choose whether they add daily principal payments to the per diem interest or begin the loan amortization on the first day of the month.

The borrower’s standard loan cycle begins on August 1 with their first monthly payment due on September 1. The standard payment on September 1 covers interest and principal for the entire month of August.