You’ve probably heard or have been instructed to close escrow at the end of the month as opposed to mid-month or early on in the month. In fact, many borrowers may have been led to believe that they can save money on interest if they close late in the month.
The reality of the situation is that you’ll be paying the money somewhere, whether it’s rent at your old place (or a different mortgage payment). It’s just of a matter of when the interest is paid. So what really drives this decision is upfront out-of-pocket expenses, which result from the amount of prepaid interest due at closing.
So what is “prepaid interest” anyways?
Well, prepaid interest is essentially the amount of interest due at closing to cover the period of time in the month between the date the mortgage lender closes your loan and the date your first mortgage payment is due.
So if your loan closes on the 15th of the month, you’ll need to pay 15 days of prepaid interest at closing. If your mortgage closes toward the end of the month, you may just need prepaid interest for a day or two. The difference in closing costs can be significant for homeowners, especially as the loan amount rises.
If you’re strapped for cash, which many homeowners are when buying their first home, every penny counts. As prepaid interest can really add up, many homeowners opt to close at the end of the month to reduce their upfront closing costs.
*Smart mortgage brokers and lenders will typically disclose enough prepaid interest for 15 days or more on the Good Faith Estimate to ensure borrowers have enough money to cover the costs no matter what day the loan actually closes.
And remember, it’s not always easy to time these things, so it’s better to overestimate, especially if you’re cutting it close with limited funds. The last thing a borrower needs is to be short on funds at the tail-end of the funding process.
Let’s look at an example of prepaid interest:
Say you close your loan on June 10th, paying 20 days of prepaid interest at closing. While you’ll have to pay that interest upfront, your first mortgage payment won’t be due until August 1st. Nearly two months to worry about coming up with the funds for your first mortgage payment ain’t bad right?
However, if you close on say June 30th, and pay only one day of prepaid interest, your first mortgage payment will be due August 1st as well, so that first mortgage payment will be fast approaching. While you’ll pay less interest, your mortgage payment will be fast approaching. Enter “time value of money.”
One final thing to note that you may not have considered is that most closings occur at month-end, meaning it’s always a frantic time for title and escrow companies. If you buck the trend and close early in the month or mid-month, you’ll have a lot more time devoted to your loan. Conversely, lenders do push loans a lot harder at the end of the month, so it’s never an easy decision.
Tip: All that said, you shouldn’t buy a home if the amount of prepaid interest can make or break you. So be sure you have sufficient funds regardless of when you close your loan.