What is Simple-Interest Mortgage
A simple-interest mortgage is a home loan with the calculation of interest is on a daily basis. This mortgage is different from a traditional mortgage where interest calculations happen on a monthly basis. On a simple-interest mortgage, the daily interest charge is calculated by dividing the interest rate by 365 days and then multiplying that number by the outstanding mortgage balance. If you multiply the daily interest charge by the number of days in the month, you will get the monthly interest charge.
Because the total number of days counted in a simple-interest mortgage calculation is more than a traditional mortgage calculation, the total interest paid on a simple interest mortgage will be slightly larger than for a traditional mortgage.
BREAKING DOWN Simple-Interest Mortgage
A simple-interest mortgage is calculated daily, which means that the amount to be paid every month will vary slightly. Borrowers with simple-interest loans can be penalized by paying total interest over the term of the loan and taking more days to pay off the loan than in a traditional mortgage with the same rate. At the same time, a simple-interest loan used along with bi-weekly payments or early monthly payments can be used to pay off the mortgage before the end of the term. This early payoff can significantly reduce the total amount of interest paid.
The differences between a simple-interest mortgage and a traditional mortgage are more critical for longer-term house notes. For example, on a 30-year fixed-rate $200,000 mortgage with a 6 percent interest rate, a traditional mortgage will charge 0.5 percent per month (6% interest divided by 12 months). Conversely, a simple-interest mortgage for the 30-year fixed-rate $200,000 loan costs 6% divided by 365, or .016438 percent per day.
Early Loan Payoffs Benefits Simple-Interest Mortgage Holders
In a traditional mortgage, a payment made on the first, or the tenth, or fifteenth of the month is the same. Since the calculation is on a monthly basis, no more interest accrues in that time which would not have customarily accumulated. However, in a simple-interest mortgage interest increases every day, so a borrower who pays even one day late will have accrued even more interest.
A borrower who pays early or on time every month will end up paying the amount before the interest accrues.
When a borrower pays more than what is due on any scheduled payment, those extra funds credit to the loan's principal. Paying extra on the traditional mortgage can reduce the principal amount consistently. This consistent payment will shorten the amount of time it takes to pay off the loan and reduce the total amount of interest paid over the life of the loan.
There is no benefit to making extra payments on a simple-interest mortgage. However, there is a risk for borrowers who do not intend to pay off the note early. Since interest compounds daily, the principal, or the amount due, continues to increase on a daily basis. This constant increase means that simple-interest mortgages are ideal only for borrowers who know they can pay early or on time every month or bi-weekly. A borrower who needs even a few days grace period every month, even if they can make occasional extra payments, may do better with a traditional mortgage.