January 7, 2008

What truly distinguishes simple interest mortgages from others is that they accrue interest daily rather than monthly. All mortgages are simple interest in not charging interest on prior interest, except those that allow negative amortization.

"I am perplexed at what appears to be a nomenclature problem that the mortgage industry has created with its definition of ‘simple interest mortgage’. Aren’t most monthly payment mortgages simple interest?"

They are, and I agree with you that the existing nomenclature can be confusing to borrowers.

Two separate concepts are involved. One is a distinction between simple interest and compound interest. The second is a distinction between monthly and daily interest accrual periods. Borrowers who don’t understand these distinctions may not manage their mortgage properly.

Simple Interest Vs Compound Interest

"Simple interest" means that interest is not paid on interest. With "compound interest", interest is (or can be) paid on interest.

The distinction is best understood in connection with savings instruments. Suppose a bank pays an annual rate of 3%, or .25% a month. On a $100,000 deposit, the account would earn $250 in month one. If it was a simple interest account, the bank would also pay $250 in month two. If it was a compound interest account, it would pay interest of $250.60 in month two, the 60 cents being the interest on the $250 earned in month one.

If the bank paid simple interest, the depositor could withdraw the $100,250 after month one and place it in another bank which would pay interest on the entire amount. This would impose needless cost on depositors. To my knowledge, there are no simple interest deposit accounts. Nobody objects to banks paying depositors interest on interest. As I note below, however, some people do object to lenders charging interest on interest.

Mortgages can also be simple interest or compound interest. However, all mortgages are simple interest except those involving negative amortization, where the payment does not cover the interest. (If unpaid interest is added to the balance, as it is on a negative amortization loan, in future months, interest is calculated on a balance that includes unpaid interest, which makes it a compound interest loan.) Absent negative amortization, all mortgages are simple interest.

Monthly Accrual Vs Daily Accrual

The interest accrual period is the period over which interest is credited. If interest is credited monthly on a savings account, as in my earlier example, the consumer who withdraws an account before the month is up receives no interest for the month. If interest accrues daily on that account, it would earn $8.22 the first day, with the interest credit rising slightly over the month as each day’s interest is added to the previous day’s balance.

Mortgages can also accrue interest monthly or daily. With monthly accrual, the quoted annual rate (say 6%) is divided by 12 and that number is multiplied by the loan balance at the end of the preceding month to get the interest due for the month. With daily accrual, the annual rate is divided by 365 and that number is multiplied by the loan balance at the end of the preceding day to get the interest due for the day.

The Two Kinds of Mortgages

With reference to simple versus compound interest and monthly versus daily accrual periods, there are two kinds of mortgages in the US. One accrues interest monthly, and is simple interest except when it allows negative amortization, when it is compound interest. This mortgage has no special name because most mortgages are of this type.

Note: Monthly accrual mortgages may use daily accrual at the very beginning and very end of their lives. If they close on any day of the month except the first, they will accrue interest daily from the closing date to the first day of the following month. This is called "per diem interest". If they are prepaid in full or refinanced, interest is charged from the last day of the preceding month to the closing date. An exception is FHAs, where a full month's interest must be paid. See Mortgage Closing Date: Does It Matter?

The second kind of mortgage accrues interest daily and is always simple interest. This kind of mortgage ought to be called a "daily accrual mortgage" because that would clearly distinguish it from the standard mortgage. But it isn’t, it is called a "simple interest mortgage". That can be confusing because most standard mortgages are also simple interest, but that is the practice.

	Monthly Accrual	Daily Accrual
Simple Interest	All Other Mortgages Without Negative Amortization	"Simple Interest Mortgage"
Compound Interest	Negative Amortization Mortgage

I suspect that a major reason for the prevailing nomenclature is lender sensitivity to the legal environment. Legal prohibitions against the practice of charging interest on interest have been enacted at various times in some states. By designating their daily accrual loans as simple interest loans, lenders are in effect advertising that they are not charging interest on interest.

Borrowers can avoid confusion if they understand that a "simple interest mortgage" is one that accrues interest daily, and should be managed differently than monthly accrual mortgages. With a daily accrual mortgage, every day that borrowers delay their payment results in the accrual of another day of interest. The grace period is not a period free of interest but the period within which they must pay to avoid an additional late charge. The smart borrower with a daily accrual mortgage consistently pays early.

If the mortgage is not simple interest, then it is a monthly accrual mortgage on which the grace period is an interest free period. The smart borrower consistently pays at the end of the grace period.