What are the pros and cons of a simple-interest mortgage?
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.