Simple Interest Mortgages: A Trap For the Unwary
October 16, 2006, Revised April 29, 2008, December 18, 2008
The more I learn about simple interest mortgages (henceforth SIMs), the more aware I have become that my previous articles on the subject understated the risks they pose for borrowers. This is true of What Are Simple Interest Mortgages? and Amortizing a Simple Interest Mortgage.
I placed too much emphasis on the fact that a borrower with disciplined payment habits can manage a SIM at no more cost than a standard mortgage with the same interest rate and term. But very few borrowers have that kind of discipline. Most slip up now and then, and for them a SIM can be a trap.
On a SIM, interest accrues daily instead of monthly Consider a 30-year 6% mortgage for $100,000. On the monthly accrual version that is the standard in the US, 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 .06/12 x 100,000 = $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, the interest due is the same.
On the SIM version of the same mortgage, the borrower owes .06/365 x 100,000 = $16.44 of interest daily. On the first day of the month when the first payment is due, he owes $16.44 x 30 = $493 if the prior month had 30 days, $510 if it had 31. If he pays on the first, those are the amounts he owes.
If he pays after the first, however, he owes another $16.44 for every day he is late. If he pays on the 10th, he owes $164.40 more than if he paid on the first.
On a 30-year 6% loan, the total payment of principal and interest is $599.56 for both a standard mortgage and a SIM. On the standard mortgage, $500 goes to interest as calculated above, and the remaining $99.56 to principal, reducing the loan balance by that amount. The borrower will pay a late fee for a payment beyond the grace period, but the allocation of the payment between interest and principal is not affected by when during the month the payment is made.
On the SIM, in contrast, the allocation between principal and interest depends 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 7 days or more, interest will absorb the entire payment and there will be no reduction in the balance.
Since interest on a SIM is charged daily, there is no rationale for a late charge, but lenders impose one anyway -- because they can. A late fee on a standard mortgage is completely reasonable, but late fees on SIMs are an abuse.
Borrowers are credited for payments when the payments are posted by the lender, not when they are sent by the borrower. Every day of delay generates another day of interest income, and if the lender delays posting the payment past the penalty-free period, the borrower will be billed for a late fee as well.
This means that borrowers who want to avoid the slippery slope have to adjust their payment practices to the posting procedures of the lender. This is difficult to do unless they receive monthly statements. Not all servicers provide monthly statements.
You might think that the mortgage note would show whether or not a mortgage was a SIM, but that is not the case. I looked at a simple interest note yesterday and it didn’t have a clue. I knew it was a SIM only because the borrower and his lawyer told me it was.
Evidently this is typical. One reader reported to me that she had a standard mortgage for several years, which was then converted to a SIM when it was sold to another lender. When she complained, the lender informed her that all the mortgages they purchased were converted to SIMs if the notes did not preclude it.
The possibility that a standard mortgage with an ambiguous note can be converted to simple interest is scary. Truth in Lending is no help because lenders are not required to identify loans as SIMs.
Until December 18, 2008 I was not aware that the standard fixed-rate note developed by Fannie Mae and Freddie Mac precludes treatment of the loan as simple interest. This was pointed out to me by a reader, and I confirmed it. The standard note says that "Each monthly payment will be applied as of its scheduled due date", which is a beautifully succinct way of preventing daily interest accruals. Any borrowers who have been converted to simple interest on the sale of servicing, who find this language in their note, have a strong case for redress.
The more I learn about simple interest mortgages (henceforth SIMs), the more aware I have become that my previous articles on the subject understated the risks they pose for borrowers. This is true of What Are Simple Interest Mortgages? and Amortizing a Simple Interest Mortgage.
I placed too much emphasis on the fact that a borrower with disciplined payment habits can manage a SIM at no more cost than a standard mortgage with the same interest rate and term. But very few borrowers have that kind of discipline. Most slip up now and then, and for them a SIM can be a trap.
Interest on a Simple Interest Versus a Standard Mortgage
On a SIM, interest accrues daily instead of monthly Consider a 30-year 6% mortgage for $100,000. On the monthly accrual version that is the standard in the US, 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 .06/12 x 100,000 = $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, the interest due is the same.
On the SIM version of the same mortgage, the borrower owes .06/365 x 100,000 = $16.44 of interest daily. On the first day of the month when the first payment is due, he owes $16.44 x 30 = $493 if the prior month had 30 days, $510 if it had 31. If he pays on the first, those are the amounts he owes.
If he pays after the first, however, he owes another $16.44 for every day he is late. If he pays on the 10th, he owes $164.40 more than if he paid on the first.
Amortization on a Simple Interest Versus a Standard Mortgage
On a 30-year 6% loan, the total payment of principal and interest is $599.56 for both a standard mortgage and a SIM. On the standard mortgage, $500 goes to interest as calculated above, and the remaining $99.56 to principal, reducing the loan balance by that amount. The borrower will pay a late fee for a payment beyond the grace period, but the allocation of the payment between interest and principal is not affected by when during the month the payment is made.
On the SIM, in contrast, the allocation between principal and interest depends 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 7 days or more, interest will absorb the entire payment and there will be no reduction in the balance.
Late Charges on Simple Interest Mortgages
Since interest on a SIM is charged daily, there is no rationale for a late charge, but lenders impose one anyway -- because they can. A late fee on a standard mortgage is completely reasonable, but late fees on SIMs are an abuse.
Simple Interest Encourages Inefficient Payment Processing
Borrowers are credited for payments when the payments are posted by the lender, not when they are sent by the borrower. Every day of delay generates another day of interest income, and if the lender delays posting the payment past the penalty-free period, the borrower will be billed for a late fee as well.
This means that borrowers who want to avoid the slippery slope have to adjust their payment practices to the posting procedures of the lender. This is difficult to do unless they receive monthly statements. Not all servicers provide monthly statements.
Recognizing a Simple Interest Mortgage
You might think that the mortgage note would show whether or not a mortgage was a SIM, but that is not the case. I looked at a simple interest note yesterday and it didn’t have a clue. I knew it was a SIM only because the borrower and his lawyer told me it was.
Evidently this is typical. One reader reported to me that she had a standard mortgage for several years, which was then converted to a SIM when it was sold to another lender. When she complained, the lender informed her that all the mortgages they purchased were converted to SIMs if the notes did not preclude it.
The possibility that a standard mortgage with an ambiguous note can be converted to simple interest is scary. Truth in Lending is no help because lenders are not required to identify loans as SIMs.
Form 3200 Multistate Fixed Rate Note
Until December 18, 2008 I was not aware that the standard fixed-rate note developed by Fannie Mae and Freddie Mac precludes treatment of the loan as simple interest. This was pointed out to me by a reader, and I confirmed it. The standard note says that "Each monthly payment will be applied as of its scheduled due date", which is a beautifully succinct way of preventing daily interest accruals. Any borrowers who have been converted to simple interest on the sale of servicing, who find this language in their note, have a strong case for redress.