Knowing the type of interest you pay on a loan can prevent you from making detrimental financial decisions.
Many loans charge simple interest, the most attractive form of interest on any loan. Hereâs everything you must know about the simple interest formula, how it works, and when it applies.
Buying a home is likely one of the biggest financial decisions you’ll ever make. With so many mortgage options available, it can be overwhelming trying to determine which type of loan is right for you. One term you may come across in your research is a simple interest home loan. But what exactly does that mean?
In this comprehensive guide, we’ll explain everything you need to know about simple interest mortgages, including how they work, their benefits and drawbacks, and whether this type of loan is a good fit for your home buying needs.
What Is a Simple Interest Home Loan?
A simple interest mortgage calculates interest on a daily basis rather than monthly like a traditional mortgage loan. With a simple interest loan, the interest rate is divided by 365 to determine the daily interest amount. This daily interest is then multiplied by the number of days in the month to calculate the monthly interest charge.
Because interest accrues daily, the total interest paid over the life of a simple interest loan will be slightly higher than a standard loan. However, the difference is usually marginal on a year-to-year basis.
How Does a Simple Interest Home Loan Work?
The main difference between a simple interest mortgage and a traditional mortgage is the frequency of interest calculations. Here’s a quick breakdown:
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Simple interest mortgage Interest accrues daily based on the outstanding loan balance Your monthly payments will vary slightly each month.
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Traditional mortgage Interest is calculated monthly by applying the interest rate to the outstanding balance. Your monthly payment stays the same
With a simple interest loan, if you pay even one day late, you will be charged additional interest for those days. On the flip side, if you pay early or make an extra payment, less interest will accrue compared to a traditional mortgage.
Over the life of the loan, you may pay a little more in total interest with a simple interest mortgage. But the difference is usually marginal, especially if you make payments on time each month.
The Pros and Cons of Simple Interest Home Loans
Like any financial product, simple interest mortgages have both advantages and disadvantages to consider.
Pros of Simple Interest Home Loans
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Pay loans off faster: Making extra or early payments reduces interest charges, allowing you to pay off your loan faster.
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Smaller interest charges: If you pay on time consistently, you’ll pay less interest each month than with a traditional mortgage.
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Flexibility: Simple interest loans can be useful if you plan to make large lump sum payments, pay bi-weekly, or pay off your mortgage early.
Cons of Simple Interest Home Loans
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Higher total interest: You may pay a slightly higher total interest amount over the full term of the loan.
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No grace period: You must pay on time each month to avoid accruing extra interest charges.
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Unpredictable payments: Your monthly payment fluctuates slightly based on the number of days.
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Prepayment penalties: Some lenders charge fees for paying off a simple interest loan early. Be sure to ask!
Is a Simple Interest Mortgage Right for You?
Whether a simple interest home loan is a good choice depends largely on your financial situation and priorities as a homebuyer.
Here are a few key questions to ask yourself:
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Are you disciplined about making payments on time? With no grace period, late payments quickly add extra interest charges.
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Do you plan to make extra or early payments? Simple interest loans reward disciplined borrowers who make consistent on-time or early payments.
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Are you comfortable with fluctuating monthly payments? Your payment will vary slightly each month based on interest calculations.
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How long do you plan to keep the mortgage? The benefit of potentially lower interest payments accumulates over time.
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Will you face prepayment penalties? Make sure you understand any fees for paying off a simple interest loan early.
If you’re highly organized and plan to pay down your mortgage aggressively, a simple interest loan could be a good fit. But if you want payment predictability and flexibility, a traditional fixed-rate mortgage is likely the safer option.
Simple Interest vs. Traditional Mortgage Examples
Let’s look at some examples to see the differences between simple interest and traditional mortgage payments over time.
For both loans, we’ll assume:
- 30 year term
- $200,000 loan amount
- 6% interest rate
Month 1
Simple Interest
- Daily interest: 0.0164% (6% / 365 days)
- Days in month: 30
- Monthly interest: 0.49% (0.0164% x 30 days)
- Monthly payment: $1,164 (includes $1,000 principal and interest)
Traditional Mortgage
- Monthly interest: 0.5% (6% / 12 months)
- Monthly payment: $1,199 (includes $1,000 principal and interest)
In the first month, the payment on a simple interest loan is lower since less interest has accrued.
Year 1
Simple Interest
- Total interest paid: $5,940
- Remaining principal: $194,060
Traditional Mortgage
- Total interest paid: $5,994
- Remaining principal: $194,006
After one year, the simple interest loan has a slightly lower remaining balance due to less interest being charged each month.
Year 10
Simple Interest
- Total interest paid: $65,688
- Remaining principal: $134,312
Traditional Mortgage
- Total interest paid: $65,994
- Remaining principal: $134,006
Over 10 years, the total interest paid is still lower for the simple interest loan, but only by about $300.
The longer you keep the mortgage, the more the interest savings add up. But on a year-to-year basis, the monthly payment and interest differences are minimal.
Finding the Best Simple Interest Home Loan Rates
If you decide a simple interest mortgage aligns well with your homebuying goals, here are some tips for getting the best rates:
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Check with multiple lenders. Interest rates and fees can vary between lenders.
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Ask about discounts. You may get a lower rate by paying points upfront or setting up automatic payments.
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Look for first-time homebuyer programs. State and local programs provide low down payment options and below-market interest rates.
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Get preapproved. Preapproval locks in a competitive rate while you search for a home.
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Improve your credit. Just a small boost in your score can mean better mortgage rates.
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Compare ARM vs fixed-rate. Adjustable-rate mortgages sometimes have lower initial interest rates.
Finding the right loan requires weighing many factors: your goals as a homebuyer, future plans for the home, financial situation, and more. With research and mortgage rate shopping, you can determine whether a simple interest home loan is your smartest option.
Simple Interest Mortgage FAQs
What is the difference between simple interest and APR on a mortgage?
Simple interest is solely the cost of borrowing money without compounding interest. APR or Annual Percentage Rate reflects the total yearly costs of a mortgage, including interest, fees, and other charges. So while simple interest will be lower, APR gives you a complete picture of the true costs.
Do all mortgage lenders offer simple interest loans?
Most major lenders will offer simple interest mortgages, but always verify with the lender first. Simple interest loans are less common than traditional mortgages but are available.
How does simple interest affect mortgage amortization?
On a simple interest loan, more of your payment goes to interest at the beginning of the term. Over time as the balance decreases, the share going to interest also declines because it’s recalculated each month.
Can you convert a traditional mortgage to a simple interest loan?
Unfortunately, you cannot convert an existing traditional mortgage to a simple interest loan. You would need to refinance your current mortgage and choose a new lender that offers simple interest loans.
Are ARM loans simple or compound interest?
Adjustable-rate mortgages can use either simple or compound interest. The initial rate is set as simple interest but may change when the interest rate adjusts on an ARM. Read all terms carefully.
The Bottom Line
Simple interest home loans offer both advantages and drawbacks compared to traditional mortgages. For some borrowers, the opportunity to pay less interest through on-time payments or pay down the balance faster can provide real savings. But for others, the lack of payment predictability and higher lifetime interest costs make standard loans a better value.
Carefully consider your unique situation – income, budget, plans for the home, financial discipline – to decide if a simple interest mortgage aligns with your priorities as a homebuyer. With research and mortgage shopping, you can find competitive rates and terms for financing your new home, whether you opt for a simple interest or traditional loan.
Simple Interest And How To Reduce Mortgage Costs
Simple interest works differently depending on your mortgage type, whether itâs a fixed-rate or adjustable-rate mortgage.
What Kinds Of Loans Use Simple Interest?
Most short-term loans use simple interest, as do mortgages. Common short-term loans include personal and auto loans. This means you donât pay interest on interest, like you do with credit cards.