A:

The basic disadvantage of a simple interest mortgage lies in the fact that unless the borrower conscientiously makes all of his mortgage payments on time, he could end up paying substantially more in interest than he would if he had a standard mortgage. However, the one potential advantage of a simple interest mortgage is that if the borrower regularly makes his payments early, he can actually end up paying less in interest than he would have if he had a standard mortgage.

The difference between a simple interest mortgage and a standard mortgage is a difference in the manner the interest on the loan is calculated. Both are simple interest accrual loans. Simple interest mortgage in this context does not mean that the mortgage features simple interest while a standard mortgage has compound interest. It is merely a term used to distinguish the two types of mortgage loans. The interest on a simple interest mortgage is calculated daily, in contrast to a standard mortgage loan on which the interest is calculated monthly. The interest calculation for a simple interest mortgage is done by dividing the interest rate by 365 and then multiplying that figure by the outstanding principal balance. With a standard mortgage, the interest rate on the loan is divided by 12 to get the monthly interest rate, and then the outstanding principal loan balance at the end of the preceding month is multiplied by that monthly rate to calculate the amount of interest due for the current month.

The amount of interest paid on a simple interest mortgage, assuming that all monthly mortgage payments are paid on time, is still slightly higher than the amount that is due on a standard mortgage, because the total number of days figured into the calculation is greater. For example, assuming a $100,000, 30-year mortgage at 6%, an individual who has been making all of his payments on time with a simple interest mortgage pays approximately $400 more in interest than would be the case with a standard mortgage. The difference in total interest payments, and therefore the disadvantage of a simple interest mortgage, is amplified by higher interest rates.

If the simple interest mortgage borrower regularly makes payments 10 days early, he realizes significant savings in total interest payments compared to having a standard mortgage. Conversely, if he is regularly 10 days late making monthly payments, he pays a significant penalty in additional interest.

Borrowers who regularly make extra payments to principal still fare better with a standard mortgage over a simple interest one, because most mortgage lenders credit any extra payments made in the first 20 days of the month to the preceding month's principal balance.

RELATED FAQS
  1. What are the different types of subprime mortgages?

    Clarify your understanding of subprime mortgages. Learn about the different types, how they work and when they might be beneficial. Read Answer >>
Related Articles
  1. Personal Finance

    Understanding the Mortgage Payment Structure

    We explain the calculation and payment process as well as the amortization schedule of home loans.
  2. Personal Finance

    Score a Cheap Mortgage, Here’s How

    Hidden costs can create what looks like a good deal. Find out how to find the best mortgage possible.
  3. Personal Finance

    Reduce Interest With An All-In-One Mortgage

    "Offset" mortgages combine a checking account, home-equity loan and mortgage into one account.
  4. Personal Finance

    How to Use a Mortgage Calculator to Save Time and Money

    Calculate your monthly mortgage payment using the Investopedia's free calculator.
  5. Insights

    How Interest Rates Affect the Housing Market

    Understand how rate changes can affect home prices and learn how you can keep up.
  6. Personal Finance

    Make A Risk-Based Mortgage Decision

    Find out how to choose which mortgage style is right for you.
  7. Personal Finance

    Which Is Better: A 30-Year or a 15-Year Mortgage?

    Most homebuyers compare the monthly payments between mortgages, but what about these other points?
  8. Investing

    Understanding The Mortgage Payment Structure

    While a mortgage’s size and term set the baseline, the interest, taxes and insurance all influence the amount of the monthly payment.
  9. Personal Finance

    Should I Consolidate My Two Mortgages?

    Consolidating your loans or mortgage may make sense for you, especially when interest rates are low. Here's what you should know.
  10. Retirement

    Additional Streams of Income for Seniors

    Find out how a reverse mortgage can work in your favor during retirement.
RELATED TERMS
  1. Home Mortgage

    A home mortgage is a loan given by a bank, mortgage company or ...
  2. Second Mortgage

    A type of subordinate mortgage made while an original mortgage ...
  3. Simple-Interest Mortgage

    A mortgage where interest is calculated on a daily basis, as ...
  4. No-Cost Mortgage

    A mortgage refinancing situation in which the lender pays the ...
  5. CMG Plan

    A mortgage plan in which a borrower's mortgage is structured ...
  6. Primary Mortgage Market

    The market where borrowers and mortgage originators come together ...
Trading Center