Prepaid Interest and Real Estate Closings

In the Chicago area, there's always a rush to close real estate transactions on (or near) the last day of the month.  This rush is usually explained as resulting from the requirement that a buyer prepay interest for the month of closing.  At first glance, this makes sense -- isn't it better to close on the 31st of the month and pay one day of interest than to close on the 1st and pay thirty days of interest?  But let's look a little deeper. 

First, some background.

Mortgages are paid in arrears.  So, if you close on your new house on July 15, your first mortgage payment won't be due until September 1.  Your September 1 mortgage payment will include interest for the month of August.  Your October 1 mortgage payment will include interest for the month of September.  And so on.

"Prepaid interest" results from the fact that, under the above fact scenario, you haven't paid any interest for the period from July 15 to July 31.  You have to prepay that interest at the July 15 closing. 

However, what do you really lose by not closing at the end of a month?  Not much, really.  If you close on August 1 instead of July 31, you are paying your August interest on August 1 instead of on September 1.  There's a time value of money advantage to making this payment later, but it's fairly small -- what's the value of holding on to, say, $1,000 for an extra month?

Furthermore, consider that, if you close on August 1 instead of July 31, you won't have to make your first mortgage payment until October 1.  If your monthly payment is more than the amount of prepaid interest, it might make more financial sense to work it this way.

It's also important to think about what you gain (in a non-financial sense) by closing at some time other than the end of the month.  Most title companies are a madhouse at the end of the month -- your closing could very well be delayed.  By contrast, there tend to be very few closings scheduled at the beginning of the month, which makes for a far more pleasant experience for buyers (and their attorneys).

Thanks to the posters at the ISBA Transactional Law Discussion Group for bringing this issue to my attention.