Wednesday, January 28, 2009
First Payments Are Paid At Close... Why?
It can be summarized by stating that the first payment of a home mortgage, whether it's a real estate refinance or a home purchase loan, is always paid forward. All other payments for a mortgage are paid "back".
Let's explore this with an example.
Mary closes her new loan on the 15th of January. That means the loan has funded and recorded. If it's a home purchase loan, she has been given her keys. If it's a refinance, the new rate kicks in.
At Mary's closing, she was given a settlement statement otherwise known as a HUD-1. ON this HUD-1 Mary sees all the expenses of her loan. Expenses such as: loan costs, appraisal fees, title costs, tax expenses, closer fees AND her first payment among other costs.
The line item that we are discussing is called "prepaid interest". It's labeled prepaid interest because the first payment to the bank, the one that is always paid at the closing table, is always interest only- no principle. Banks are authorized, only on the first payment, to collect interest ahead of time to the end of the month.
Banks cannot collect any interest unless they have earned it. Which means that all payments after the first "interest only" payment, are paid backwards. The reason for this paying back is because borrowers will start using the money hence banks start earning the interest as the month ticks off. Once the month ticks off, the lender sends a coupon for the month that was just used.
Why is the bank allowed to collect the first payment in advance? This grace period is given to banks so that they can their administrative and loan servicing roles. Loan servicing, is the process of managing and collecting payments.
If Mary closes her loan on the 15th, she will pay all the interest forward (unearned yet by the bank) from the 15th to the end of the month. Stay with me... she has paid the interest forward to the end of the month, now the loan converts to the normal process of paying backwards. Does she have to pay for February on the 1st of February? No, because now the bank has to earn the interest and send a coupon for the month earned. Mary's first payment will be due March 1 paid back for all of February.
Remember, the first payment is always paid forward, and all the other payments are paid back. Whether the loan closes on the 1st, 2nd, 10th, 15th, 28th or 29th it is paid to the end of the month. If it closes on the 29th, then Mary owes two days interest. If it closes on the 1st, Mary owes 30 days interest.
People like to close their loans at the end of the month, so that their closing costs, reflected through less days of prepaid interest, are lower.
Closing costs saved by paying the prepaid interest at the end of the month are important if someone is low on savings- closing at the end of the month is cheaper. However, closing at the end of the month is also riskier because "everyone" is trying to close at the end of the month, and delays do happen.
Usually most closing entities are going nuts in the last five days of the month. If you can avoid closing at the end of the month do so. Try closing between the 15th and the 25th for less anxiety.
