November 2, 2017

Over the years, I have received a steady flow of inquiries and complaints about simple interest mortgages (SIMs), and have written several articles explaining how they work and how borrowers should deal with them. In doing this, I always viewed SIMs as the product of outdated practices, which in time would disappear. Only recently have I become aware that they are not disappearing, that they are much more common than I had thought, and that the Federal agencies that could make them go away, or at least mandate adequate disclosures, have been looking the other way.

How a SIM Differs From a Standard Mortgage

On a standard mortgage, interest is calculated monthly, the monthly payment is due on the first day of the month, and the payment is recorded as paid on that date even when it is delayed. The note stipulates a 10 or 15-day “forbearance” period during which payments received are recorded as paid on the first.

For example, if the loan is closed April 1 for $100,000 at 4% for 30 years, the payment is $477.42, and it is due May 1. The interest portion is .04/12 x 100,000 = $333.33. The $144.09 difference between the payment amount and the interest charge is deducted from the balance to yield a new balance of $99,855.91. If the payment is not made until later in May, so long as it is received within the forbearance period, the result is the same. 

On a SIM, interest is calculated daily and there is no forbearance period. The daily rate is .04/365 = .0001096, so the daily interest charge would be .0001096 x 100,000 = 10.96. On May 1 the interest due would be 10.96 x 30 = $328.80, which is a little less than on the standard mortgage because there are only 30 days in April. With the interest charge a little less, the remaining balance would be a little lower at 100,000 – [477.42 – 328.80] = 99,851.38.

But this assumes that payment is made on May 1. If payment is made later or earlier, the results are different, as shown in the table: 

Mortgage of $100,000 at 4% For 30 Years, Payment of $477.42 Due May 1

Actual Payment Date	Standard Mortgage		Simple Interest Mortgage
	Interest Charge	New Balance	Interest Charge	New Balance
April 25	$333.33	$99,855.91	$274.00	$99,796.58
May 1	$333.33	$99,855.91	$328.80	$99,851.38
May 10	$333.33	$99,855.91	$438.40	$99,960.98
May 15	$333.33	$99,855.91	$493.20	$100,015.78

 

SIMs Can Ensnare Unwary Borrowers

To pay off the SIM loan balance on schedule, the borrower must make the payment on or before the due date every month. Further, the payment date is not the day a check is placed in the mail, or even delivered in person to the office of the servicing agent. It is the date when the agent records the payment as received, which doesn’t happen until a check clears.  In my example, if the borrower doesn’t pay until the 15^th, his loan balance will rise rather than decline.

I have heard from borrowers who made payments on SIMs for years without ever making a dent in the amount they owed. In most such cases, the borrower was unaware of how their mortgage worked.

Beating the SIM With Early Payments

The one potential advantage that a SIM offers the borrower is a credit for early payment. Note in the table that when payment is made on April 25, the monthly interest due on the standard mortgage remains the same while the SIM borrower pays only 25 days of interest. But this is a one-time saving, don’t assume that if you pay regularly on the 25^th of the month, your interest charge will continue to cover only 25 days. From the 25^th of one month to the 25^th of the month following is 30 or 31 days. The only borrowers who would obtain a continuing benefit are those who can make their monthly payments consistently over a shorter interval, such as every 25 days or every four weeks. I doubt that there are many of those.

Public Policy Regarding SIMs

There are two justifiable policies. One is to make SIMs illegal, because the number of consumers who can use one advantageously is miniscule compared to the number who are disadvantaged. A second rational approach would be to require that lenders disclose that the mortgage note can (or cannot) be interpreted as allowing simple interest. Neither approach has been adopted. Borrowers must accept the risk without realizing it, and if it doesn’t hit them at the start, it can hit them later if the loan or the servicing of the loan is sold. 

Ironically, one of the major arguments for the creation of the Consumer Financial Protection Bureau (CFPB) was to replace the irreconcilable disclosures previously required by HUD and the Federal Reserve with one set of integrated disclosures, which it did. This was a major advance, but it left SIMs entirely out of the picture, for reasons CFPB has never explained.

The Potential For Fraud

Mortgage notes that allow borrowers to be charged simple interest offer firms that service loans for others a tempting opportunity: charge the borrower simple interest but credit the lender for a standard mortgage. If the borrower pays a few days late, the servicer could pocket the excess interest, crediting the lender only with the expected monthly interest. Further, the slower pay-down of the SIM loan balance would mean that the borrower would be paying the servicer after the lender had been repaid.

I don’t have any evidence that this has ever happened, but given the temptations and the large numbers of players in this market, I would be surprised if it hasn’t. In any case, it is one more reason why SIMs should either be made illegal or subject to explicit disclosure rules.

Next week: SIMs at Fannie and Freddie