Simple Mortgage Interest Vs. Compound Mortgage Interest

how does a simple interest loan work

by Philippe Lanctot

Understand mortgage interest to get the best deal possible.

Mortgage Payment

Whether the interest on your mortgage is calculated on a simple or compound basis, it will not affect the amount of your mortgage payment. A $300,000 mortgage with a 30-year term and 4 percent interest rate will have a monthly payment of $1,432.25 in both circumstances.

Interest

With a simple mortgage, interest is calculated on a daily basis. On your $300,000 mortgage at a 4 percent interest rate with a monthly payment of $1,432.25, you would divide the annual interest rate by 365 and apply it to the mortgage balance. In this case the daily interest rate would be .04/365, or 0.010959 percent. Applying this rate to the $300,000 balance yields an interest charge of $32.88 per day. This interest charge is applied every day until you make a payment, and a new daily interest charge is calculated based on the reduced principal amount. With a compound mortgage, your interest is calculated monthly. The rate applied to

the principal would be .04/12, or 0.333333 percent, resulting in an interest charge of $300,000 * 0.00333333 = $1,000. The process repeats itself for another month on the new mortgage balance after your monthly mortgage payment is applied to interest and principal.

Monthly Variations

The interest calculation on a compound mortgage will be the same for every month, as it is based on one month elapsing each time a calculation is required. For the simple mortgage, however, the interest calculation will depend on the number of days in the month and therefore will vary depending on which month of the year you are in. For example, interest on a $300,000 mortgage balance would be $300,000 * 0.04 / 12, or $1,000 regardless of which month it is. For a simple mortgage, however, interest in February (non-leap year) would be $300,000 * 0.04 / 365 * 28, or $920.55. Using the same calculations for months of 30 and 31 days, respectively, you end up with interest charges of $986.30 and $1,019.18.

Effect of Simple Interest

Source: homeguides.sfgate.com

Category: Credit

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