Pre-Paid Interest is a Closing Cost that Often Confuses Buyers
At the close of escrow, a buyer is responsible for providing both the remainder of their down payment as well as any closing costs associated with the transaction, so that the loan can fund and the transaction can close. Pre-paid interest is a charge on the settlement statement that often confuses buyers, so let’s break it down:
Rent is paid in advance, mortgages are paid after-the-fact. By which I mean – When you make a rent payment at the beginning of the month, July for example, it is for the coming month. You pay rent on July 1 for the July rent. Mortgage interest is paid after-the-fact (in arrears, if you prefer). If you made a mortgage payment on July 1, it would be a payment for the interest that accumulated in the prior month (plus principal), in this example that would be June.
In the slide above, with a June 15 closing, pre-paid interest covers the period from June 15 (the closing date) to July 1 (when mortgage interest begins to accrue as part of the August 1 payment).
In the above slide, closing happens early in the month, which increases the amount of pre-paid interest due at closing. However, the first mortgage payment is not due until August 1 so the increase in pre-paid interest is balanced by the fact that the first mortgage payment is due farther in the future.
This slide illustrates what happens when you close later in the month – pre-paid interest will decrease. However, to balance the decrease in pre-paid interest, there are fewer days between the close of escrow and the first payment on the mortgage being due.
Some people prefer to close later in the month because it lowers their closing costs – as you can see, though, in the end it is all a wash because closing later in the month just reduces the number of days before your first payment to the bank is required.
So should you close early or late? In my opinion, it really doesn’t matter – the bank makes sure they will be paid their interest sooner or later, when you close only affects how that interest payment is made.
Don’t forget to check out our San Francisco homebuyer’s guide if you found this information helpful.