October 22, 2015

“I represent a couple facing the foreclosure of their home…My clients' loan is currently being calculated as a daily simple interest loan which is causing them to be in default…Attached is a copy of the note, deed of trust, and a payment history…” 

Your clients had terrible payment habits, which made them ill-equipped to handle a simple interest mortgage (henceforth “SIM”).  

A borrower with disciplined payment habits can manage a SIM at virtually the same cost as a standard mortgage with the same rate and term, but few borrowers have the required discipline. Most will slip up now and then, which will cost them more than the standard mortgage would have in the same circumstances. And for some borrowers, the SIM can be a financial quicksand from which they can never extricate themselves. This was the case for your clients.  

 The Major Issue Is Disclosure: There is nothing wrong with the SIM being an option that the borrower can choose, provided that the differences between the SIM and the standard mortgage are clearly disclosed. The borrower who selected the SIM would then understand the differences, and would adjust her budgetary practices to them. But I have yet to see a SIM being offered in transparent fashion. The practice is to foist the SIM on a borrower who doesn’t understand the difference, which is inexcusably sneaky. And in some cases, standard mortgages are converted to SIMs because the note allows it, which is even less excusable and should be illegal.   

The Major Difference Is In the Calculation of Interest Due: The calculation of the monthly payment on a SIM and a standard mortgage is the same. For example, on a 30-year loan for $100,000 with a rate of 6%, the monthly payment is $599.56 in both cases.  

The major difference is that the interest due is calculated monthly on the standard mortgage, and daily on the SIM. On the standard mortgage, the 6% is divided by 12, converting it to a monthly rate of .5%. The monthly rate is multiplied by the loan balance at the end of the preceding month to obtain the interest due for the month. In the first month, it is $500.

On the SIM version, the annual rate of 6% is divided by 365, converting it to a daily rate of .016438%. The daily rate is multiplied by the loan balance to obtain the interest due for the day. The first day and each day thereafter until the first payment is made, it is $16.44.

The SIM Accrual Account: The $16.44 is recorded in a special accrual account, which increases by that amount every day. No interest accrues on this account, which is why it is called "simple interest". When a payment is received on a SIM, it is applied first to the accrual account, and what is left over is used to reduce the balance. When the balance declines, a new and smaller daily interest charge is calculated. But if the payment is not large enough to pay off the accrual account, the balance and interest rate remain unchanged and the accrual account continues to grow.  

Budgetary Implications: Borrowers who pay every month on day 1 reduce their loan balance on a SIM almost as well as on a standard mortgage. Over 30 years, they will have to pay a month or two longer, due to leap years which add an extra day’s interest to the tab.  

SIM borrowers who persistently pay early will pay off the balance before the scheduled term. Persistent early payment is the way to beat the SIM. Aside from avoidance, it is the only way. 

Borrowers who persistently pay late do much worse with a SIM. The SIM borrower who persistently pays on day 10, for example, won’t pay off the 30-year 6% loan until the 32^nd year.  

Borrowers with erratic payment habits fare the worst of all because of the likelihood that at some point their payment won’t cover the amount in the accrual account. That is the quicksand that your clients fell into. They fell so far behind that they could never catch up, and ended up owing far more than they had borrowed originally.    

Recognizing a SIM When You See One:  Your clients claim that they were never told that they were getting a SIM. I examined their note, and there is nothing in it that indicates it was a SIM. For example, the rate shown in the note is the annual rate divided by 12, which gives the monthly rate. The daily rate used in a SIM is not shown in the note. That it is permissible to show a monthly rate in the note but charge the borrower a daily rate is a glaring deficiency of the disclosure rules. 

A Message to the Consumer Financial Protection Bureau (CFPB): Your new mortgage disclosure requirements continue to allow lenders to be ambiguous on whether the mortgage described in their notes is a standard monthly accrual type, or a SIM. This would be really easy to fix.