Understanding a Simple-Interest Mortgage

Have you ever heard of simple-interest mortgages (SIMs)?

If not, you probably should — so that you understand the risks these loans may pose for borrowers. Like 50-year home loans, there are very clear drawbacks. While a borrower with disciplined habits can manage a SIM at no more cost than a standard home mortgage with the same interest rate and term, many people slip up now and then.

It’s in such cases that a SIM can be a trap. A disastrous trap.

On a SIM, interest accrues daily, not monthly. Consider a 30-year fixed-rate product at a home loan rate of 6 percent for $100,000. On the monthly accrual version that is the standard in the U.S., interest accrues monthly, and the borrower enjoys a 10-15 day grace period for paying it past the due date.

For example, the borrower owes $500 of interest for the first month. If the due date is the first of the month and the grace period is 10 days, he can pay the $500 anytime before the 11th without having to pay more. Further, it doesn’t matter whether the month has 30 days or 31.

• On the SIM version of the same home loan, you’d owe .06/365 x 100,000 = $16.44 of interest daily.
• On the first day of the month when the first payment is due, you owe $16.44 x 30, or $493 if the prior month had 30 days, $510 if it had 31.

• If you pay on the first, those are the amounts you owe.
• If you pay after the first, however, you will owe another $16.44 for every day you are late. If you pay on the 10th, you will owe $164.40 more than if you had just paid on the first.

The implications on amortization are also key to understanding these loans. On a 30-year, 6 percent home loan, the total payment of principal and interest is $599.56 for both a standard mortgage and a SIM. On a regular mortgage, $500 goes to interest as calculated above, and the remaining $99.56 to principal, reducing the loan balance by that amount.

When you go to pay off a mortgage of the conventional variety, the borrower will pay a late fee for a payment beyond the grace period if that takes place, but the allocation of the interest and principal is not affected by when during the month the payment is made.

The SIM, by contrast, alters the allocation between the principal and interest depending on the day the payment is credited. Any delay in the payment raises the part going to interest and reduces the part going to principal by the same amount. If the payment in the example is late by seven days or more, interest will absorb the entire payment and there will be no drop in the home mortgage loans‘ balance.

SIMs also have late fees. Since interest on a SIM is charged daily, there is no rationale for a late charge, but a mortgage lender will often impose one anyway — because they can. A late fee on a standard mortgage is reasonable, but late fees on SIMs are an abuse.

Then there’s the inefficient payment processing.

Borrowers are credited for payments when they are posted by the lender, not when they are sent by the borrower. Every delay generates another day of income, and if the mortgage company delays posting the payment past the penalty-free period, the borrower will be billed for a late fee as well.

Borrowers who want to avoid the slippery slope have to adjust their payment practices to the posting procedures of the lender. This is difficult unless they receive monthly statements.

Recognizing a SIM is hard to do. Sadly, truth-in-lending standards do not mandate lenders identify loans as SIMs. You might think that the mortgage note would show whether a mortgage was a SIM, but that is not the case. The responsibility to make the payments — and understand them — is on you.
You must be aware and ask all the right questions. We suggest you make use of all the tools at your disposal, such as a mortgage calculator, and ask all the right questions of your lender to understand just how your rates are arrived at. This is too important an investment to take any chances with.