A Simple Interest Mortgage Can Cost You
One of the small pitfalls to look out for when shopping for a mortgage has to do with simple interest vs. a standard mortgage. Although the term "simple interest" sounds harmless, it can cost you money if you're not careful.
A simple-interest mortgage is one where the interest charges are calculated on a daily basis, as opposed to once a month on a regular mortgage. There's no difference between the two if you always pay your mortgage exactly on the due date each month, but if you tend to pay a few days late, it will cost you.
Many borrowers tend to pay their mortgages "late" each month because most mortgages have a grace period of about two weeks before any late fees are assessed. So if your mortgage is due on the first but you typically get your payment to your servicer around the 15th, that's half a month of additional interest (not to mention running the risk of getting hit with a late fee if the mail delivery is running a bit slow!).
A higher loan balance
True, the actual amount of additional interest is fairly small - you're only paying additional interest on the amount of your principal payment for the month. For example, suppose you owe $200,000 on your mortgage and $500 of your current monthly payment is going toward the principal. With a simple interest loan, for each day your payment is late, the interest rate is charged against a balance of $200,000 instead of $199,500.
For the $500 difference, the interest isn't much - about 32 cents a day on a loan with an interest rate of 6 percent, or $3.20 if you typically pay 10 days late. But over the life of the loan, it can add up. On a 6 percent mortgage with simple interest, paying 10 days late consistently means more than three additional mortgage payments at the end of a 30-year loan - a period that gets even longer as the interest rate goes up or the longer you delay making your monthly payments.
The problem for many borrowers is that they assume simple interest is normal. When their mortgage lender tells them "Oh, it's just simple interest" it sounds like the most straightforward, least expensive thing to do. But it's not.
Early mortgage payments can save
Simple interest can have an upside if you're the type who likes to make your mortgage payments early. In that case, each day you make your payment ahead of your due date will save you money, instead of costing you. But relatively few borrowers find themselves able to do that on a consistent basis. You don't get a benefit for paying a standard mortgage a few days early, since the interest is still calculated once a month.
One more thing - even if your lender tells you you're getting a standard mortgage, it might not stay that way unless it's specifically written into the mortgage contract. Some mortgage servicers have been known to convert standard interest mortgages to simple interest when acquiring a mortgage if the loan terms don't specifically prohibit them from doing so. So it's a good idea to make sure your loan agreement specifically states you're getting a standard mortgage at the outset.
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