A pre-paid item is something that MUST be paid, in advance of, (or in actuality, concurrently with) a mortgage transaction being completed, regardless of the lender (or broker) you’re dealing with. This is a **non-negotiable, mandatory item and is tied more to the type and conditions of your loan, versus the lender arranging your financing.
For instance, an FHA loan might “require you” to have an escrow account where you pay property taxes and hazard insurance to the lender along with your principal and interest payment, where a conventional loan may not. In this scenario, you’ll have certain pre-paids associated with that FHA loan that wouldn’t be associated with a conventional loan that doesn’t require an escrow account.
Points, (or Loan Origination fees), on the other hand, are **negotiable, non-mandatory items, that you pay to the entity arranging financing for you. This “fee” is charged as the total or partial compensation for their work, or, in order to get you a particular interest rate.
Pre-paid items are either a pro-rated portion of a given mandatory expense associated with owning the property or a pre-determined advance amount of a given mandatory expense. Points, in contrast, are “percentages of the loan amount” and are charged in factors/multiples of eighths of a percent, (or .125%) of the loan amount.
Examples of typical pre-paid items are things like, property taxes, hazard insurance, and loan interest.
An example of a pro-rated pre-paid item works like this: As of the day you take ownership of the property in a purchase transaction, (or the effective date of your new loan in a refinance), you pay taxes and interest from that date, until the first of the next month, even if your first payment isn’t due until what is considered to be 2 months later. Assuming your transaction completed on the 15th of the month and the monthly cost of the pre-paid item is $300, your prepaid amount would be $150 to complete the transaction.
An example of the pre-determined advance amount would be the requirement to pay 3 months worth of property taxes, in advance, (at loan closing), to be held in an escrow account and paid by the lender to the taxing authority on your behalf when the property taxes become due. This amount is paid along with the monthly portion required in your regularly scheduled monthly payment. Assuming annual taxes of $6000, a 3 month advance requirement at document signing would make your pre-determined advance amount required a loan closing to be $1500 to complete the transaction.
Assuming the two above items were your only prepaids, your prepaids would cost you $1650.
Assuming a loan amount of $250,000 and a 1 Point fee, the price of the points on that loan are $2500.
Points are generally a tax deductible item, where pre-paids are not.
Points are not “necessarily” a “bad thing” when you consider that this is how the person that arranges your financing earns their living. They also give you the ability to “ buydown” your interest rate to one lower than you qualify for, in order to decrease your monthly payment as well as gives you the means to truly compare one lender’s offering to another. Depending on the purpose of the points being charged, points, as non-mandatory items can also be negotiated down to zero. However this will almost always result in a higher interest rate, and thus a higher monthly payment.
Points, or discount points are fees paid at the time of closing to obtain a lower interest rate. Technically you are prepaying interest to obtain a lower rate. More on that below. Prepaid interest is an interest charge that covers the interest due on your loan from the date of funding. Here’s a little more detail on each:
**Discount Points: Discount Points are fees paid at closing, to lower your interest rate for the life of your loan. An example may be as follows – a par interest rate on a 30 year fixed is 6.00%, and you are borrowing $200,000. You may also obtain a rate of 5.75% if you pay 1 ‘point’. A point is equal to 1% of your loan amount, so in this case, 1 point would be $2,000 (1% x $200,000). Paying this charge upfront will allow you to save money each month because you will be paying lower interest. You can also buy fractional points, as they move in increments of 1/8th of a percent. It is also worth noting that how much a point can buy varies by day and by loan program. Some days buying discount points is more beneficial than others, this generally depends on the overall mortgage backed securities market and what type of spread exists between coupons at that time. That information however, is less important than understanding that there is no fixed rule of exactly how much lower a point will buy your rate down.
**Prepaid Interest: Prepaid interest on a loan equals the amount of interest you pay per day on your loan (per diem interest) times the number of days left in the month you are closing. The reason behind that is this, on the day your loan funds, your bank is actually lending out money. They expect to be paid interest from the time the money is lent out. The problem lies in the fact that mortgage interest is paid in arrears, this means for example that when you make a payment on June 1st you are actually paying the interest that accumulated from May 1st through May 31st. Because of this, you typically skip 1 month of payment at the time of closing, the problem is that you need to make up the interest due for the remainder of the closing month, thus, prepaid interest. Here’s an example –
You close on a loan for $200,000 at 6%, on June 15th. It’s a purchase loan so it funds June 15th as well. So you have 15 days from the time the money was lent, to the end of the month. Since you close in June, you have no house payment due in July, your first payment is due in August. The August payment will clear the interest due in July, but what about the 15 days of interest from the closing date in June to the end of the month? You have to pay that at closing (prepaying interest that is not yet due, thus prepaid interest). So at closing you would pay $32.88 per day (per diem interest on $200,000 at 6.00%) for 15 days, or $493.20 at the time of closing.