Are Mortgages Simple Interest and Compounded Monthly?

November 21, 2017 No Comments »
Are Mortgages Simple Interest and Compounded Monthly?

People seem to be fascinated with how mortgages are calculated and paid off, but when it comes down to it, there’s nothing too mind-blowing happening.

Each month, a portion of principal and interest are paid off as mortgage payments are made. Over time, the loan balance is reduced, as is the total amount of interest due.

Mortgages Are Simple Interest

Here in the United States, mortgages use simple interest, meaning it is not compounded. So there is no interest paid on interest that is added onto the outstanding mortgage balance each month.

Conversely, think of an everyday saving account that offers you compounding interest. If you have a balance of $1,000 and an interest rate of 1%, you’d actually earn more than 1% in the first year because that earned interest is compounded either daily or monthly.

Put another way, you earn interest on your interest each day or month, which allows your money to grow more quickly.

Mortgages don’t do that because the total amount of interest due is already calculated beforehand and can be displayed via an amortization schedule.

For example, a $300,000 mortgage set at 4% on a 30-year fixed mortgage will have total interest due of $215,610 over the life of the loan. We know this beforehand because mortgages are amortized.

Each month, the combined principal and interest payment will be exactly the same, but the composition of the payment will change.

In month one, you’ll pay $432.25 in principal and $1,000 in interest for a total of $1,432.25.

In month 360, you’ll pay the same $1,432.25, but only about $5 of that amount will go toward interest because the outstanding loan balance will be so small at that time.

At no point would you pay interest on top of interest.

Extra Payments Compound Principal

However, if you paid an extra $100 each month on top of your required mortgage payment, the principal portion would start compounding.

In month one, you’d pay $1,532.25, with $1,000 going toward interest and $532.25 going toward the principal balance.

This wouldn’t provide any extra benefit in the first month because you’d simply be paying $100 extra to get $100 more off your principal balance.

However, in month two the total interest due would be calculated based on an outstanding balance that is $100 lower. And because payments don’t change on a mortgage, even more money would go toward the principal balance.

The second payment would be $998.23 in interest and $534.02 in principal.

Meanwhile, those making the standard monthly payment with no extra amount paid would pay $998.56 in interest and $433.69 in principal.

That’s more than a $100 difference, $100.33 to be exact. And over time, this gap will widen. In month 60, the principal payment would be $121.70 higher on the loan where you’re paying an extra $100 per month.

So the benefit of paying extra increases more and more over the life of the loan and eventually allows the mortgage to be repaid early.

Are Mortgages Compounded Monthly?

As noted, traditional mortgages don’t compound interest, so there is no compounding monthly or otherwise.

However, they are calculated monthly, meaning you can figure out the total amount of interest due by multiplying the outstanding loan amount by the interest rate and dividing by 12.

Using our example from above, $300,000 multiplied by 4% and divided by 12 months would be $1,000. That represents the interest portion of the payment only. The $432.15 in principal is the remaining portion, and it lowers the outstanding balance to $299,567.75.

In month two, the same equation is used, this time multiplying $299,567.75 by 4% and dividing by 12 months. That yields total interest of $998.56.

And because the monthly payment is fixed and does not change, that must mean the principal portion of the payment rises. Sure enough, it’s a slightly higher $433.69.

In other words, the interest due for the prior month is calculated on a monthly, not daily basis. This means it doesn’t matter when you pay your mortgage, as long as it is within the grace period.

Generally, mortgage lenders allow you to pay the prior month’s mortgage payment by the 15th of the month with no penalty, even if the payment is technically due on the first of the month.

Because interest isn’t accrued daily, but rather monthly, it doesn’t matter if you pay on the first or the 15th. As long as the payment is made on time, the same amount of interest will be due, and the same amount of principal will be paid off.

To complicate matters, because the mortgage industry does that really well, there are so-called “simple interest mortgages” that calculate interest on a daily basis. Instead of calculating the amount of interest due by dividing by 12 (months), you divide by days (365) instead.

These types of mortgages are not the norm, but if you happen to have one, the day you pay your mortgage will matter because interest is calculated every single day, even on leap years.

That could make paying even a day later more expensive. But as mentioned, most mortgages are calculated monthly so it shouldn’t be an issue for many people.

Neg Ams Are the Only Mortgages That Compound Interest

To tie up some loose ends, there is one type of mortgage that compounds interest, and it too isn’t very common these days.

The once very popular option arm, or pick-a-pay mortgage, which features negative amortization, allows for compounding interest.

It does so because borrowers are allowed to pay less than the total amount of interest due for the month, which adds any shortfall to the outstanding loan balance.

This means the borrower pays interest on top of interest in subsequent months if they don’t pay the full amount of interest due. The banks are happy to let it ride, but the borrower is the one who pays for the convenience.

Again, these mortgages are pretty much a thing of the past, but it’s one good example of a mortgage with compounding interest.

In summary, for most individuals their mortgage will be simple interest that is calculated monthly. That means no new interest will be added to the loan balance and all calculations will be made on a monthly basis, so paying early or late in the month should have no effect, as long as payment is received by the due date (or within the grace period).

(photo: Jayel Aheram)

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