January
5, 2004
"What are the benefits/drawbacks of a
simple interest loan versus a traditional mortgage? Which would you take
if offered the choice?"
I would select a traditional mortgage. If
two loans are exactly the same but one is simple interest, you will pay
more interest on it unless you systematically make your monthly payment before
the due date.
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.
The $16.44 is recorded in a special
accrual account, which increases by that amount every day. No interest
accrues on this account. When a payment is received, 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.
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.
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. Most lenders will credit extra payments
received within the first 20-25 days of the month against the balance at
the end of the preceding month. A borrower who pays $1,000 extra on day
20, for example, will save the interest on that $1,000 for 20 days. With a
simple interest mortgage, in contrast, interest accrues for those 20 days.
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.
Days to Payoff and Total Interest Payments on a Standard Mortgage and Simple Interest
Mortgage of $100,000 for 30Years Beginning January 1, 2004
|
|
Standard
Mortgage,
Payment Within Grace
Period
|
Simple
Interest Mortgage
|
|
Payment 10 Days Early
|
Payment on First Day of Month
|
Payment 10 Days Late
|
|
Days
to Payoff
|
|
|
|
|
|
6% Loan
|
10,958
|
10,918
|
10,990
|
11,059
|
|
12% Loan
|
10,958
|
10,704
|
11,049
|
11,424
|
|
Total
Interest
|
|
|
|
|
|
6% Loan
|
$115,832
|
$115,180
|
$116,167
|
$117,160
|
|
12% Loan
|
$270,277
|
$261,889
|
$273,359
|
$285,414
|
