Question: I recently went to settlement on a zero closing cost refinance. The settlement statement showed a credit of $2850 from the mortgage broker, which was the total amount of the closing costs. Despite the credit, I had to come up with almost $2,200 in order to close. I never got a clear answer as to why I owed this money. Shouldn't a zero closing cost refinance mean I shouldn't have to pay anything at settlement?

Answer: No. The amount of the check that you write at settlement has very little to do with whether or not you took out a zero cost loan. Understanding the settlement statement is very important to anyone taking out a mortgage. Let's start from the beginning.

First, a zero cost refi means that in exchange for a slightly higher interest rate -- usually a quarter percent -- the mortgage broker is able to pay your transactional closing costs. I refer to these items as "sunken costs," and include expenses such as the appraisal fee, settlement agent fee, lender underwriting fee, county recording fee, etc. These sunken costs can certainly add up to $2,850.

Of course, there's no free lunch. You took a higher rate instead. In most cases, taking a higher rate with no closing costs is better than "buying down" your rate, costing you thousands in points and fees. But that's a subject for a different column.

The amount of cash owed, if any, at the settlement table when refinancing is determined by the new loan amount, not whether or not the borrower actually pays closing costs. Most lenders will require that you set up an escrow account for the periodic payment of real estate taxes and insurance. My guess is much of the $2,200 that you had to come up with was applied towards this escrow deposit. Let's look at all the items involved in a refinance.

• The pay-off of the old loan. This is usually the first source of confusion. The pay-off amount of a mortgage is not equal to the principal balance. Lenders will include any unpaid interest into the pay-off figure. Remember that mortgage payments are made in arrears, not in advance. The daily interest from the last time a mortgage payment was made to the actual date of pay-off will be added to the principal balance.

• Prepaid interest to the new lender. Prepaid interest is simply the daily interest owed to the new lender from the day of settlement to the end of the month. There's an ongoing myth in real estate that suggests you receive an interest-free month if you settle at the end of the month because you avoid the pre-paid interest. This is baloney. The first mortgage payment is always due after the first full month. A settlement on October 31st, for example, would mean the borrower would not pay any pre-paid interest. His first mortgage payment would be due on December 1st. A settlement date of November 1st would mean the borrower would pre-pay November's interest at settlement. But his first mortgage payment isn't due until January 1st. It all comes out even in the wash.

• Escrows for taxes and insurance. This is an initial cash deposit made to the new lender so it is able to pay the real estate and insurance bills when they become due. The escrow account is replenished every month because your mortgage payment will include one months' portion of the annual taxes and insurance. Hence the term, PITI (Principal Interest, Taxes & Insurance) Payment.

• Closing Costs. Unless you signed up for a zero cost loan, expect to pay plenty for the items necessary to close the deal.

Okay, the only way a borrower would not have to write a check at the settlement table is if the new loan amount was equal to the sum of these items. Let's look at your situation. Your closing costs were zero, so we needn't worry about that one. Your final loan amount is obviously $2,200 less than the sum of your pay-off figure, escrow deposit and pre-paid interest.

You can expect to get some or all of the $2,200 back from two sources. First, remember that your first mortgage payment isn't due until the end of the first full month that you hold the mortgage. This probably means that you won't owe a payment on the first of the next month. Second, the old lender is undoubtedly holding some of your money it its escrow account. When that loan is paid off, they need to reimburse you whatever the balance is in that account -- it's your money. Expect a check in the mail.

My guess is that your loan officer didn't take the time to explain how this works. Full disclosure and explanation at the time of application is crucial to avoid last minute surprises.

Published: November 11, 2004

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, the president of PMC Mortgage Corporation in Alexandria, VA, is a mortgage columnist whose work has appeared in numerous consumer, real estate, and mortgage publications. Mr. Savage welcomes your questions for possible use in this column, however because of the volume of mail received, Mr. Savage cannot answer questions individually.