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Hi all -- first time poster here. After researching the issue of prepaid interest, I still had a lingering question.
I think I get it, for the most part. In short, the borrower pays the amount of interest between the date of close and the first of the next month. (I frankly don't understand why the borrower can't just pay the interest for those days on that first of the month, but that's besides the point.)
Now, all the resources I've read explain that the out-of-pocket expenses are the same regardless of when you close. Either you close early in the month and pay more up-front (and get more time before you have to pay your first mortgage payment). On the other hand, if you close late in the month, you pay less up-front (but pay your first mortgage payment sooner). I get that, in theory, but I don't understand how these two things are equal.
Here's why: If I close on April 30 and pay 1 day of prepaid interest, then on June 1, I make my first mortgage payment (principal + interest). That seems great. I pay practically nothing in prepaid interest, live for a month, then I pay my normal mortgage payment on June 1.
But, say I close on April 1 and pay a big 29 days of prepaid interest. Then, I live for 2 months without paying, then pay my first mortgage payment on June 1. While that seems fine, my first payment is PURE interest, with absolutely no payment going towards principal? Why would I want to do that? Isn't that not great? The difference might be slight in the long run, but doesn't that make these two options actually different? Not to mention that I'm also giving up time-value of that money.
Lets start assuming your talking about a rate and term refi and not a purchase. Funds due at closing are calculated this way:
Payoff + Closing costs + Prepaid interest + escrow account deposit= total liability that must be staisfied. From this total you subtract your new loan amount and those are the funds due at closing.
Your payoff consists of your principle balance + outstanding daily interest + any outstanding fees.
Now lets dial in to just the daily interest on the old loan and the prepaid interest on the new loan. Assuming there are 30 days in the month you close and your old loan has $40 a day in interest with you new loan having $30 a day in interest. Closing on the 1st of the month you pay $40(1 day) to old lender and $870(29 days) to new lender for a total of $910. Now on the 15th of the month its $600 to the old lender and $450 to the new for a total of $1050. You can see the pattern here that your going to pay interest to someone for every day you have an outstanding balance. You add it to the payoff or line item it on the HUD as prepaid interest. Its in your best interest to get into the new loan and lower rate as soon as you can and don't wait until the end of the month because its actually costing you money.
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