If two loans are exactly the same but one
is simple interest, I would take the traditional mortgage. You will pay
more interest on the simple interest mortgage unless you systematically make your monthly payment before
the due date.
Calculating
Interest on a Simple Interest Mortgage
The major difference between a standard
mortgage and a simple interest mortgage is that interest is calculated
monthly on the first and daily on the second.
Consider a 30-year loan for $100,000 with
a rate of 6%. The monthly payment would be $599.56 for both the standard
and simple interest mortgages. The interest due is calculated differently,
however.
On the standard mortgage, the 6% is
divided by 12, converting it to a monthly rate of .5%. The monthly rate is
multiplied by the loan balance at the end of the preceding month to obtain
the interest due for the month. In the first month, it is $500.
On the simple interest version, the annual
rate of 6% is divided by 365, converting it to a daily rate of .016438%.
The daily rate is multiplied by the loan balance to obtain the interest
due for the day. The first day and each day thereafter until the first
payment is made, it is $16.44.
[Note: On many commercial mortgages, the
annual rate is divided by 360 instead of 365, making the daily rate a little
larger.]
The $16.44 is recorded in a special
accrual account, which increases by that amount every day. No interest
accrues on this account, which is why it is called "simple interest". See
The Nomenclature of Simple
Interest Mortgages, or
Mortgage Concepts Homebuyers Should Know.
When a payment is received on a
simple interest mortgage, it is applied first
to the accrual account, and what is left over is used to reduce the
balance. When the balance declines, a new and smaller daily interest
charge is calculated.
Total Interest
Payments on a Simple Interest Mortgage
How does this work out for the borrower?
We know that a standard 30-year mortgage pays off in 30 years. Beginning
January 1, 2004, this amounts to 10,958 days. On a loan of $100,000 and an
interest rate of 6%, total interest payments amount to $115,832.
On the simple interest version of the same
mortgage, assuming you pay on the first day of every month, you pay off in
10,990 days, or 41 days later than with the standard mortgage. Total
interest payments are $116,167 or $335 more.
These are small differences, due largely
to leap years. Over the 30 years beginning 2004, there are 8 years with
366 days, and the lender collects interest for those days. Leap years do
not affect total interest payments on a standard mortgage.
The disadvantage of a simple interest
mortgage rises with the interest rate. At 12%, and continuing to assume
payment on the first day of every month, it pays off in 11,049 days or 91
days later than the standard mortgage. Total interest is $3082 higher.
Total Interest
When Payments Are Late
But the borrowers who really get clobbered
by the simple interest mortgage are those who pay late. The standard
mortgage has a grace period within which borrowers can pay without
penalty. On a simple interest mortgage, in contrast, borrowers pay
interest for every day they are late.
Suppose the borrower pays on the 10th
day of every month, for example. With a standard mortgage, he gets a free
ride because of the grace period. With a simple interest mortgage at 6%,
he pays off 101 days later than the standard mortgage and pays $1328 more
interest. At 12%, he pays off 466 days later and pays $15,137 more
interest.
Penalties for payment after the
grace period work the same way on both types of mortgage. For this reason,
I have not included penalties in the calculations.
Borrowers making extra payments
also do better with a standard mortgage. A borrower who includes an extra
$1,000 in his regular monthly payment, for example, will save the interest
on that $1,000 for each day the payment is late, provided it is within the
grace period. With a simple interest mortgage, in contrast, interest accrues
for those days.
Making Payments
Early
The only transaction that works out better
for the borrower with a simple interest mortgage is monthly payments made early.
If every month you pay 10 days before the payment is due, for example, you
pay off 40 days sooner than the standard mortgage at 6%, and 254 days
earlier at 12%. There is no benefit to early payment on a standard
mortgage, since it is credited on the due date, just like a payment that
is received 10 days late.
Bottom line: other things the same, take
the standard mortgage. But if you are stuck with a simple interest
mortgage, make it a habit to pay early; it will pay big dividends.
Note: Simple interest biweekly mortgages
raise other issues. See Simple
Interest on a Biweekly.
