- The Washington Times - Thursday, September 30, 2010

One of the most important aspects of a refinance is making sure the borrower understands why he may need to write a check at the settlement table.

I get this question all the time: “If there are no closing costs with the refinance, why would I need a check at settlement?”

Let’s use my zero-closing-cost refinance program as an example.

The answer is easy. Whether a borrower pays closing costs has nothing to do with whether he will have to write a check at settlement. Owing money at settlement is a function of the loan amount for which the borrower was approved.

Let’s say I refinance a borrower whose existing balance is exactly $300,000. I lower his interest rate from 5.25 percent to 4.75 percent, and he pays no closing costs. One might think that if I make his new loan amount exactly $300,000, he would neither owe nor receive money at settlement because the new loan would be equal to the balance of the old loan. Unfortunately, it’s not quite that simple.

Even though there are no closing costs, two items still need to be paid at settlement. One is interim interest, which is collected by both the old lender and the new lender. The amount each lender collects depends upon the size of the loan and on what day of the month settlement occurs, but the total interim interest shouldn’t exceed much more than 30 or 35 days’ worth.

Let’s say I schedule my borrower for his $300,000 refinance to settle on Oct. 10. He comes to the table and sees the payoff amount to his old lender isn’t $300,000, but $300,604.

My borrower objects because he confirmed a week earlier that the principal balance was, indeed, $300,000. The settlement agent explains that mortgage payments are made in arrears, rather than in advance. This means each mortgage payment covers the interest for the previous month.

When my borrower made his Oct. 1 payment, it covered interest due from Sept. 1 through Sept. 30. Because the refinance settlement date is Oct. 10 and the federally mandated rescission period extends the funding day to Oct. 14, the old lender is adding 14 days of interest to the balance.

Similarly, the new lender will charge about 17 days of interest at settlement. This is called “prepaid interest,” and it covers the period from the settlement date to the end of the month.

So the sum of the old lender’s accrued interest and the new lender’s prepaid interest amounts to the mortgage payment that would be due Nov. 1. Because October’s interest is paid at settlement, my borrower doesn’t owe a payment on Nov. 1.

This is where the myth originates that a homeowner “skips a mortgage payment” when he refinances. That’s nonsense. It’s true that a payment isn’t owed on the first day of the next month after a refinance, but it’s not “skipped.” It was either paid at settlement or added to the new loan amount.

The other cash item a borrower needs to be aware of is the escrow deposit. Almost all lenders require paying the real estate taxes and homeowner’s insurance through an escrow account. The borrower pays into the escrow account each month as part of the mortgage payment - hence the term PITI, or principal, interest, taxes and insurance.

The new lender will collect several months’ taxes and insurance to open the escrow account. This amount will be enough to ensure that the amount collected, plus future PITI payments, will be enough to pay the next tax and insurance bills. When the old lender is paid off, it must close any escrow account and return any monies to the borrower.

Here’s what my client wishing to refinance his $300,000 mortgage can expect if he instructs me to make the new loan amount $300,000:

  • He will owe about $1,500 in interim interest, which covers the month of October. His first mortgage payment won’t be due until Dec. 1.
  • He will owe several months’ real estate taxes and homeowners insurance, which could total $3,000 or $4,000. If the old lender escrowed properly, a similar amount should be refunded about three weeks after settlement.

A good loan officer will explain this procedure carefully at the time of application to ensure there are no surprises.

Send e-mail to henrysavage@pmcmortgage.com.

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