The phrase per diem is a Latin term that means “for a day” in English. In finance, per diem interest simply refers to the total amount of interest that accrues or that’s earned on a loan on a daily basis. It’s calculated by dividing the total amount of annual interest being charged on a loan by the total number of days in the calendar year.
For example, assume that someone takes out a loan for $100,000 US Dollars (USD) at an annual interest rate of 5 percent. To figure out what the amount of per diem interest would be, the following formula would apply: total loan amount multiplied by the interest rate, divided by 365 days. In this example, the borrower would multiply the loan amount of $100,000 USD by the interest rate of 5 percent for a total of $5,000 USD. The borrower would then divide the $5,000 USD by 365 days to come up with the daily interest of $13.70 USD.
Per diem interest rates primarily come up in the context of mortgages when a buyer closes on a day other than the first of the month. In this case, the per diem interest is ordinarily what the buyer is responsible for paying at closing before the lender takes over the note. Since most mortgage lending companies calculate loans from the first of the month, a per diem rate helps simplify loan administration before the lender officially begins servicing the mortgage. Essentially, it is an interest payment made by the buyer on the loan before the buyer officially begins making payments.
If a loan closes on 27 March, for instance, the buyer’s first mortgage payment would ordinarily be due on 1 May, and that payment would include all of the interest for the month of April. The buyer would be required to pay per diem interest for the leftover dates in March — 28, 29, 30, and 31 March. The amount of daily interest owed would be calculated using the formula above. Generally, the buyer would be responsible for paying the total amount of per diem interest as part of his or her closing costs.
It’s important to note that per diem interest is not the same thing as interest that is compounded daily. Compound interest generally comes up in the context of investments rather than in the context of borrowing money. With compound interest, interest is earned on the initial money that was invested as well as on the interest that has already accumulated. When interest is compounded daily, an investor earns interest every single day.