April 30, 2014

“I recently discovered that the second mortgage I have had for 9 years was simple interest, which explains why I have made barely a dent in paying down the balance…The payment due date is the 11^th of each month but the lender arranged for automatic payment on the 25^th, without explaining to me that this would result in additional interest every month…do I have a legal case?”  

I looked at your note and you do indeed have a simple interest mortgage (SIM). The lender certainly should have explained the implications of simple interest to you, but the disclosure rules don’t require it, so I doubt that you have a legal case. But perhaps we can save some other innocent borrowers from making the same mistake. 

One thing that struck me about your note is that the simple interest provision is explicit, all you had to do was read the note and figure out how to protect yourself, which you did not do. In some other notes I have seen, the wording is so general that simple interest is not mandated but neither is it barred. In that situation, the only way to know whether or not it is a SIM is to examine the servicing statements that show how your loan is amortizing – more about that below.   

Sometimes, loans that allow but don’t mandate simple interest are not treated as SIMs by the lenders who originated them, but at some point the servicing of the loans is sold to another firm, who converts them into SIMs. This year, the servicing of millions of loans has been sold to specialized servicing firms, with many more to come. This is a good time, therefore, for borrowers to make sure that their mortgage has not been converted into a SIM, and if it has, to develop a plan for protecting themselves. It isn’t all that difficult once you know the drill.

The major difference between a standard mortgage and a SIM is that interest is calculated monthly on the first and daily on the second. Consider a 30-year 6% mortgage for $100,000, which will carry a monthly payment of $599.56 on both versions. On the monthly accrual version, the borrower owes .06/12 x 100,000 = $500 of interest for the first month. It doesn’t matter how many days there are in the month, or when during the month he pays it, though payments after the 10-15 day grace period are penalized with a late fee. The $99.56 included in the monthly payment is used to reduce the loan balance.

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 month has 30 days, $510 if it has 31. If he pays on the first, those are the amounts he owes. But – and this is the crux of the matter -- if he pays after the first, he owes another $16.44 for every day he is late. If he pays on the 7th, for example, he owes $115.08 more than if he paid on the first. The interest in that case will exceed the payment, resulting in the loan balance going up rather than down! This is why a SIM borrower with sloppy payment habits can pay for years without making a dent in the loan balance.

Borrowers making extra payments also do better with a standard mortgage. Most lenders will credit extra payments received within the first 20-25 days of the month against the balance at the end of the preceding month. A borrower who pays $1,000 extra on day 20, for example, will save the interest on that $1,000 for 20 days. With a SIM, in contrast, interest accrues for those 20 days.

Those with SIMs also have to be wary of the lender’s schedule for processing payments. 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. With a daily interest charge, there is no rationale for a late charge on a SIM, but lenders impose one anyway -- because they can.

The only transaction that works out better for the borrower with a SIM is monthly payments made early. If every month you pay 10 days before the payment is due, for example, you pay off the balance 40 days sooner than the standard mortgage at 6%, and 254 days earlier at 12%. (I derived these numbers from a SIM spreadsheet that is available on my web site).There is no benefit to early payment on a standard mortgage, since it is credited on the due date, just like a payment that is received 10 days late.

The moral could hardly be clearer: If you find you have a SIM, you can turn the tables by making sure that every payment is posted by the lender prior to the due date.

How do you know whether or not you have a SIM? You have one if your loan is not amortizing the way a standard mortgage amortizes. Using calculator 2a on my web site, enter your initial loan balance, monthly payment and term to generate an amortization schedule. The calculator will also allow you to add extra payments, if you have made any. If the balance reported by your lender in your most recent statement is higher than the balance shown by the calculator by more than a few pennies, you almost surely have a SIM. That would be bad news, but the good news is that you now know what to do about it.