Prepaid Interest: the truth
As you probably know, when you buy a home, the bank charges interest on your mortgage every day, but for the sake of
convenience, the bank only asks that you pay once a month. This daily rate of interest is sometimes referred to as per
diem (pronounced purr DEE-um), which is latin for "per day".
With a fixed loan the payments are the same every month (barring an increase in realty taxes or insurance,
it they are escrowed, which is something we'll discuss elsewhere). But if you close on any day other than the first
or last day of the month, then the monthly payment becomes different for the first month only--so rather than confuse the
borrower, the bank charges you for that odd first payment (often called "prepaid interest") at the closing.
It is a bit misleading to call this "prepaid interest" because when you borrow a mortgage you spend the first
few years paying lots of interest and a very wee bit of "principal." Principal is the part of your payment that actually
chips away at the base amount you originally borrowed. That's why if you sell your home a few years after you buy it,
your mortgage payoff is practically as high as the original loan amount! You can actually visualize this depressing
concept by viewing an amortization chart. The chart shows the thirty year repayment schedule, and what portion of your
payment goes to principal or interest broken down by month. It's like a financial planner's version of a crystal
ball. You should usually view it while holding the hand of someone you love.
Are you still following me? Good.
Some people think that when you don't pay this "odd" payment, by closing on the first or last day of the month,
that you are saving money. Wrong! This is a myth.
The disadvantage of closing on the first or last day of the month is that you make your first ordinary payment
a whole month sooner. So, although you need less cash on the day of closing, the lender will expect the first regular
payment 30 days after closing. This is more of an issue for people who are tight for money at their closing (which
might be you). But it doesn't save you any money--anyone who tells you it does is either trying to unnecessarily
rush you into closing or doesn't understand what they are doing.
If you are suprised to learn that some people working in the "home buying industry" don't know what they are doing, then
prepare to be amazed!
On the other hand, for those lucky people that can afford to close any day (other than the first or last day of the month),
they won't have to pay that mortgage until the following month. It will feel like a payment holiday--no
rent and no mortgage payment on the first day of the month after you close! Of course, the per diem still keeps accruing,
so it won't save you any money. But after paying for a real estate closing, even the illusion of a payment holiday will
be welcome news. Trust me on this one.
