Understanding this closing cost gets a lot easier when you remember one important concept: rent is paid in advance, mortgage payments are paid in arrears. For example, if you rent a home, the rent payment you make the 1st day of the month is the cost of renting that home for that month. If you make a March 1 payment, it is to cover the month of March.
If you own a home, the same payment that you make on March 1 would be for the interest that accumulated in February and any principal you are paying down. Mortgage payments look back, rent looks forward, and this is where the pre-paid interest closing cost comes from.
Take two hypothetical closing dates. One is early in the month – let’s say March 7 (calendar above). The other is late in the month – let’s say March 28 (calendar below). Both of these homes will have their first mortgage payment due on May 1. The May 1st payment will cover all of the interest that accumulated in the month of April.
Pre-paid interest is the difference between the day when you actually borrowed the funds to buy your home and the interest included in your first mortgage payment. If you close early in the month, you will pre-pay the interest for that entire month, because the first mortgage payment will include the interest for the following month. If you close late in the month, you are only pre-paying several days worth of interest, so the amount is lower.
The early March closing has higher pre-paid interest charges (and thus, higher closing costs) but also a longer time period between the close of escrow and when the first mortgage payment is due (March 7 –> May 1). The late-in-the-month closing has lower pre-paid interest charges, but also a shorter time period between closing and the 1st mortgage payment (March 28 –> May 1).
How is the daily amount actually determined? Regardless of the number of days in the month, closing costs are always based on a 30 day month (including property taxes, HOA dues, etc.). Take the interest paid for a 30 day month, divide by 30, and that is your daily pre-paid interest amount.
If you found this article helpful, be sure to check out our homebuyer’s guide.