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Simple Interest Mortgage
Recently a bank offers you a mortgage at 7.25%.
You were well into the loan process when you discover it is a simple interest
mortgage loan. What are the benefits/drawbacks of a simple interest
mortgage loan versus a traditional mortgage? Which would you take if offered the
choice? It is confusing because the standard amortized mortgage that dominates the market also involves simple interest. The essential difference between your mortgage and the standard mortgage is that interest is calculated daily on your mortgage and monthly on the standard mortgage. Simple interest
mortgage means that interest is not paid on interest -- there is no "compounding."
For example, using a rate of 7.25% and a balance of $100,000 on both, the standard mortgage would have an interest payment in month one of .0725 times $100,000 divided by 12, or $604.17. On your mortgage, the interest payment per day would be .0725 times $100,000 divided by 365 or $19.86. Over 30 days this would amount to $589.89 while over 31 days it would amount to $615.75. Yours is called a "simple interest mortgage" because the daily interest charge within the month is constant -- interest is not charged on the interest charges of prior days.
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Comparing the two mortgages, if you make your payment on the first day of every month in both cases, over the course of a year you would come out exactly the same. But if you pay late while staying within the usual 15-day grace period provided on the standard mortgage, you do better with that mortgage. If you pay on the 10th day of the month, for example, you get 10 days free of interest on the standard mortgage whereas on your
simple interest mortgage
interest accumulates over the 10 days. Similarly, if you make an extra payment toward principal, say on the 20th day, on the standard mortgage you save the interest on that amount for the 20 days whereas on your
simple interest mortgage
interest accrues over the 20 days.
The only borrowers who will do better with the simple interest mortgage are those in the habit of making their monthly payments early. If you make your payment 10 days before it is due, you will receive immediate credit with the simple interest mortgage, saving the interest on the portion of the payment that goes to principal reduction for the 10 days. With the standard mortgage, a payment received 10 days early is credited on the due date, just like a payment that is received 10 days late. |
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California Mortgage Rate. |
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