If you are offered two types of loans that are
exactly the same, but one has simple interest, you will be paying more on interest
on a simple interest loan, unless you make your payments before the actual due
date.
The primary difference between a standard mortgage, and a mortgage
with simple interest is that in the case of the former, interest is calculated
on the first day, and in the latter case, interest is calculated daily.
Let's consider the example of a 30-year loan for $100,000 at a rate of 6%. This
is an average sort of mortgage. For both a standard and a simple interest mortgage,
your monthly payments would be $599.56. However, when it comes to interest,
the due is calculated in two very different ways.
For a standard mortgage, the 6% is divided by 12 (months), so
that it is converted into a monthly rate of 0.5%. This monthly rate is then
multiplied by the loan balance at the end of the preceding month, so that the
interest can be calculated for the month. For example, in the first month, it
would be $500.
However, if the same loan had simple interest, the annual rate
of 6% is divided by 365 (days), with a daily rate of interest of 0.016438%.
This daily rate is multiplied by the loan balance to generate the interest due
for each day. The first day, and every day after that, until the payment is
made will accrue $16.44 in interest.
This $16.44 is recorded into a special account of accrual, which
will increase by exactly that amount every single day. No interest will accrue
on this account. When a payment is received by the lending institution, it is
paid first to the accrual account, and then whatever is left is used towards
the reduction of the balance. Should the balance decline, a new, smaller daily
interest charge is calculated.
What does this mean for you? If this was your 30-year mortgage,
the amount due for a $100,000 mortgage with an interest rate of 6%, would be
$115,832.
However, if you had this mortgage with simple interest - assuming
that you made your payments on the first day of every month, you will actually
be paying off your mortgage 41 days later, and with a total of $116,167 - $335
more than you'd pay with your standard mortgage. This disadvantage rises with
the interest rate.
Bottom line: all things being the same, 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.
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