The Nomenclature of Simple Interest Mortgages - Mortgage Professor

9/19/13 2:14 PM

What truly distinguishes simple interest mortgages from

others is that they accrue interest daily rather than monthly.
All mortgages are simple interest in not charging interest on
prior interest, except those that allow negative amortization.

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The Nomenclature of Simple Interest Mortgages

January 7, 2008

What truly distinguishes simple interest mortgages from others is that they accrue interest daily rather than
monthly. All mortgages are simple interest in not charging interest on prior interest, except those that allow
negative amortization.
"I am perplexed at what appears to be a nomenclature problem that the mortgage industry has created with its
definition of simple interest mortgage. Arent most monthly payment mortgages simple interest?"
They are, and I agree with you that the existing nomenclature can be confusing to borrowers.
Two separate concepts are involved. One is a distinction between simple interest and compound interest. The
second is a distinction between monthly and daily interest accrual periods. Borrowers who dont understand
these distinctions may not manage their mortgage properly.

Simple Interest Vs Compound Interest

"Simple interest" means that interest is not paid on interest. With "compound interest", interest is (or can be)
paid on interest.
The distinction is best understood in connection with savings instruments. Suppose a bank pays an annual rate
of 3%, or .25% a month. On a $100,000 deposit, the account would earn $250 in month one. If it was a simple
interest account, the bank would also pay $250 in month two. If it was a compound interest account, it would
pay interest of $250.60 in month two, the 60 cents being the interest on the $250 earned in month one.
If the bank paid simple interest, the depositor could withdraw the $100,250 after month one and place it in
another bank which would pay interest on the entire amount. This would impose needless cost on depositors. To
my knowledge, there are no simple interest deposit accounts. Nobody objects to banks paying depositors
interest on interest. As I note below, however, some people do object to lenders charging interest on interest.
Mortgages can also be simple interest or compound interest. However, all mortgages are simple interest except
those involving negative amortization, where the payment does not cover the interest. (If unpaid interest is
added to the balance, as it is on a negative amortization loan, in future months, interest is calculated on a
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The Nomenclature of Simple Interest Mortgages - Mortgage Professor

9/19/13 2:14 PM

balance that includes unpaid interest, which makes it a compound interest loan.) Absent negative amortization,
all mortgages are simple interest.

Monthly Accrual Vs Daily Accrual

The interest accrual period is the period over which interest is credited. If interest is credited monthly on a
savings account, as in my earlier example, the consumer who withdraws an account before the month is up
receives no interest for the month. If interest accrues daily on that account, it would earn $8.22 the first day,
with the interest credit rising slightly over the month as each days interest is added to the previous days
balance.
Mortgages can also accrue interest monthly or daily. With monthly accrual, the quoted annual rate (say 6%) is
divided by 12 and that number is multiplied by the loan balance at the end of the preceding month to get the
interest due for the month. With daily accrual, the annual rate is divided by 365 and that number is multiplied
by the loan balance at the end of the preceding day to get the interest due for the day.

The Two Kinds of Mortgages

With reference to simple versus compound interest and monthly versus daily accrual periods, there are two
kinds of mortgages in the US. One accrues interest monthly, and is simple interest except when it allows
negative amortization, when it is compound interest. This mortgage has no special name because most
mortgages are of this type.
Note: Monthly accrual mortgages may use daily accrual at the very beginning and very end of their lives. If they
close on any day of the month except the first, they will accrue interest daily from the closing date to the first
day of the following month. This is called "per diem interest". If they are prepaid in full or refinanced, interest is
charged from the last day of the preceding month to the closing date. An exception is FHAs, where a full
month's interest must be paid. See Mortgage Closing Date: Does It Matter?
The second kind of mortgage accrues interest daily and is always simple interest. This kind of mortgage ought
to be called a "daily accrual mortgage" because that would clearly distinguish it from the standard mortgage.
But it isnt, it is called a "simple interest mortgage". That can be confusing because most standard mortgages
are also simple interest, but that is the practice.
Monthly Accrual

Daily Accrual

Simple Interest

All Other Mortgages Without Negative Amortization

"Simple Interest Mortgage"

Compound Interest

Negative Amortization Mortgage

I suspect that a major reason for the prevailing nomenclature is lender sensitivity to the legal environment.
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The Nomenclature of Simple Interest Mortgages - Mortgage Professor

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Legal prohibitions against the practice of charging interest on interest have been enacted at various times in
some states. By designating their daily accrual loans as simple interest loans, lenders are in effect advertising
that they are not charging interest on interest.
Borrowers can avoid confusion if they understand that a "simple interest mortgage" is one that accrues interest
daily, and should be managed differently than monthly accrual mortgages. With a daily accrual mortgage, every
day that borrowers delay their payment results in the accrual of another day of interest. The grace period is not a
period free of interest but the period within which they must pay to avoid an additional late charge. The smart
borrower with a daily accrual mortgage consistently pays early.
If the mortgage is not simple interest, then it is a monthly accrual mortgage on which the grace period is an
interest free period. The smart borrower consistently pays at the end of the grace period.
Copyright 2013 The Mortgage Professor

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