When a homeowner takes out a mortgage, you can be sure she has researched all the available rates and terms before deciding on a lender. However, one detail might not be on the radar of mortgage shoppers: whether the monthly payments will be calculated using simple interest or accrued interest. The distinction is important, and knowing it can save you money.
Mortgages are structured to allocate most of your monthly payment to interest charges in the early years. The lender makes its profit through the interest it charges, and it is eager to collect that portion first. In the first several years, very little of your mortgage payments will go to paying back the principal. The exception is for payments greater than the minimum required -- the excess directly reduces your principal. If you have an accrued interest mortgage, your monthly interest charge can be lower than that charged on a simple interest mortgage, but you’ll have to pay your bill early in the cycle to benefit.
In a simple interest mortgage, your next interest payment is based on your previous monthly balance. It doesn’t matter whether you make your payment on the first day or the last day of the billing cycle, the interest charge is the same. If you have a simple interest mortgage, you can wait to pay until the end of the billing cycle without penalty. This can give you a little more flexibility in managing your money throughout the month.
An accrued interest mortgage uses daily interest charges. The charges add up, or accrue, throughout the month. If you wait until the last day to make your monthly payment, your interest charge will be the same as that charged by an equivalent simple interest mortgage. However, if you have an accrued interest mortgage and you pay on the first day of the cycle, you save about 29 days of interest. Those avings will be applied to reducing your principal. This is a money-saving deal if you can manage to pay your mortgage at the beginning of each cycle.
What's in a Name?
To clear up a constant source of confusion: the banking industry calls a mortgage that calculates and accrues interest daily a "simple interest mortgage." Yes, this is completely counterintuitive but it is standard practice. What does the industry call a mortgage that doesn't accrue daily? It doesn't have a name, it's simply a mortgage.
Negative Amortization Mortgage
Normal mortgages do not compound interest charges. Under both the simple and accrued interest schemes, you do not pay interest on interest, though you are subject to late fees. However, a negative amortization mortgage is a different animal. These mortgages allow you to make monthly payments that are less than the accrued interest for the month. Your deficit is then added to the principal amount you owe. You can pay a negative amortization mortgage for many years but yet end up owing more than the original amount, so beware.
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