Residual Interest: What it is, How it Works, Example

What Is Residual Interest?

The term residual interest refers to the interest that may accrue on an interest-bearing account like a credit card, loan, line of credit, or mortgage. Credit card residual interest is normally charged on balances incurred between billing cycles. In this case, it may also be referred to as trailing interest. The term may also apply to an interest payment received by investors in a structured credit investment product.

Understanding Residual Interest

While borrowers are only required to make a minimum monthly payment on revolving credit accounts, many borrowers choose to pay their outstanding balance in full. Paying the entire balance on a credit account as listed on a monthly statement can be a good financial habit. But just because consumers may pay their balances off entirely, they may still be subject to interest charges. This is where the residual interest comes into play.

As mentioned above, residual interest is any interest charged on a balance incurred between the billing date and the payment due date. People who don't pay off their accounts in full and carry a balance month-to-month are subject to interest charges. Even those who believe they've paid off their balance may be charged residual interest. Here's why.

Most credit accounts calculate interest on balances daily. The standard calculation typically divides the annual percentage rate (APR) by 365 days to arrive at a daily interest rate. While a borrower may choose to pay a credit issuer the outstanding balance on their monthly statement, they must understand that interest will likely be charged daily up until the day their payment is received.

Example of Residual Interest

Generally, a borrower may not receive their statement until at least one or two days after the closing date, and it may take them another four to five days to pay off the quoted outstanding balance. This can leave approximately a week of daily accruing interest on their credit balance—or the residual interest. Thus, a credit account customer may pay off their balance but still be charged a small interest charge on their next statement due to the daily interest accrual up to the time when their payment was made.

Residual Interest and Structured Credit Products

Residual interest is also a type of interest investors may receive when investing in structured credit products such as a real estate mortgage investment conduit (REMIC). A REMIC is a structured mortgage product that may pool either residential or commercial mortgages in a special purpose vehicle for investors.

REMICs are typically structured with multiple tranches that pay varying interest rates to investors. In some cases, a REMIC tranche may be structured to pay out an unspecified amount of interest. This interest would be based on cash flow available after higher seniority tranches have been paid.

Thus some REMIC investors may receive residual interest payments after all the required regular interest has been paid to investors within higher priority tranches. In this case, residual interest functions much like common shares in that preferred shareholders receive all required dividends before any amount remaining is divided among common shareholders.

Special Considerations

Some credit card companies may allow for a grace period, which gives account holders a specified time to pay off a balance with no interest accrual. Grace periods are often associated with accounts that are paid off in full each month. The terms for a grace period are often detailed in a bank or credit card company's cardholder agreement.

The increased use of technology has enabled the real-time calculation of interest and the viewing of balances by the borrowers to pay their balances in real-time. The borrowers are then empowered to pay in real-time to avoid residual interest.

Consumers should remember that even though they've paid off their statement balance and believe they no longer owe the credit card company, they shouldn't ignore any subsequent bills. These may include any residual interest owing. Failure to keep track of and pay any trailing interest can lead to black marks on a person's credit report and late payment charges. To avoid credit-related problems, consumers should contact their lender for the full balance of the account, including interest to close, to get the most accurate payout amount.