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What Buyers Should Know About Saving on Prepaid Interest

what-buyers-should-know-about-saving-on-prepaid-interest

It’s often recommended for buyers to close at the end of the month – or at least as close to it – in order to avoid being stuck with having to pay more prepaid interest when the deal closes. This is often a good strategy to save money, but it needs to be fully understood in order to find out how much money truly is saved at the end of the day.

For starters, what exactly is prepaid interest? Simply put, it is mortgage interest that’s paid in advance. Mortgage interest is paid out in arrears, unlike rent, which is paid in advance. That means a mortgage payment that’s made on May 1st pays for the interest from April.

Borrowers usually prepay their mortgage interest on a new home loan or when refinancing an existing mortgage. The interest will be paid up to 30 days away from when the first mortgage payment is due. If your home closes on May 15th, for instance, the first mortgage payment will need to be paid on July 1st. In this case, the July payment will cover the interest for June, and the amount due to cover the time period from May 15th to the 31st will be paid at closing of escrow.

This payment is what’s known as “prepaid interest,” which essentially covers the time period during the month between when the lender closes the mortgage and the date that the first mortgage payment is due.

How Closing Near the End of the Month Can Save on Prepaid Interest

Using the above example, you would have to pay 16 days of prepaid interest (from May 16th to the 31st) at closing if the loan closes on May 15th. On the other hand, you can avoid paying much in prepaid interest if the loan closes near the end of the month. While this might not amount to much in some cases, it can result in significant savings in many other scenarios, particularly if the home loan amount is quite high.

Buyers who are struggling to come up with all the upfront closing costs might find closing near the end of the month a great way to save a few bucks in prepaid interests, no matter how nominal the amount may be. 

What Are the Downfalls of Closing at Month-End?

Borrowers should also carefully consider closing dates in terms of how soon their first mortgage payment will be due. While you will have to come up with the 16 days worth of prepaid interest amount based on the previous illustration, you won’t have to worry about having to make your first mortgage payment until July 1st. That’s quite a bit of time to prepare yourself for your first official payment.

Now consider paying just a day or two worth of prepaid interest if you close at the end of the month, say, on May 30th. In this case, you’d be saving quite a bit of money in prepaid interest, but your first mortgage payment will come much sooner compared to the previous scenario.

As such, month-end closings mean buyers will pay less in prepaid interest, but they’re only skipping one monthly mortgage payment. Closing earlier in the month, however, might mean more money paid in prepaid interest at closing, but two monthly payments can be skipped. At the end of the day, it’s not just important to figure out how much you can save, but how the date of closing that you choose can impact your cash flow.

In addition, it’s important to consider the fact that escrow and title companies are typically swamped with closing deals since the vast majority of real estate contracts close at month-end. This traffic jam at the end of the month can increase the odds of delays, which can actually wind up pushing the closing out to the beginning of the following month. At that point, buyers will need to fork over more money for the additional prepaid interest.

The Bottom Line

Closing towards the end of the month can certainly save you money in prepaid interest. However, there are other considerations to make, including how soon the first mortgage payment will need to be made and the potential for delayed closing due to busy lender schedules. Carefully consider your financial situation and determine whether you’d benefit more from cutting down on closing costs or delaying that first hefty mortgage payment.