In about half of the settlements that I conduct a seller will stop me and comment, “The payoff is too high, I owe less than what’s listed.” This is because the seller is confusing the mortgage principal balance with the payoff amount.
The principal balance is the remaining principal due on the loan. This gets reported in monthly statements from the lender and is available if you call your lender or check online. With a fully amortizing loan, part of your monthly payment is going to paying down the principal every month.
However, a payoff is the amount owed on the loan to pay it off on a specific day. Note that interest on a conventional mortgage accumulates daily*. Also keep in mind that a mortgage is paid in arrears – the monthly payment is for the prior month’s interest.
So when you make the April 1 payment, you are paying the interest due on the loan from March 1 to March 31. Consequently, if you are closing on April 10 and have already made your April 1 payment, you still owe interest from April 1 to the date of payoff.
Typically a cushion is selected so that there are sufficient funds to pay off the loan, so the amount submitted to the lender in the above scenario is likely: principal balance + per diem interest due from April 1 to April 13 equals the mortgage payoff.
The reason for the cushion is not to cheat you out of some money, though I’m sure it feels that way. It is to make sure there is not a shortage when paying off the loan. In our scenario, assuming that everything was completed in a timely manner, the seller will receive back from the payoff lender two to three days of interest that were overpaid.
So how do you determine your payoff amount?
The title company is going to order a payoff letter from your mortgage lender to find out the precise payoff amount.
What if you're trying to prepare an estimate and would like a figure?
You can always call your lender and obtain a payoff from them over the phone. Some lenders will calculate a payoff amount for you online as well. Just remember to add a few days to the closing date so that you have allowed for a cushion.
But for most estimates, using this trick will suffice: take your principal balance and add to it a monthly payment. Assuming that you are on time with your payments, this number should always be a bit higher than your actual payoff, but at least this way you will be overestimating instead of underestimating, which is typically the case when you use the principal balance as the payoff amount.
* Interest on an FHA mortgage accumulates monthly. Therefore, interest is always owed through the end of the month. However, to calculate an estimated payoff, the same concept applies: take the principal balance and add a monthly mortgage payment to obtain an estimated payoff.