Definition
Simple Interest
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Simple interest refers to interest rates on loan products that do not charge interest on interest via compounding.
For most consumers, this should be the default interest rate to charge on home loans simply because the variety of methods interest rates are calculated are too complicated for general consumers to understand.
For example, when a lender quotes 3% interest on a $100,000 home loan, the borrower might be confused as to why he is paying more than $3,000 a year on interest costs.
This is why banks often quote the interest rate of a loan, but also inform what they interest would mean when converted to simple interest.
This means that whenever you are unable to grasp why a certain interest rate is a specific amount, always ask the banker what is the interest converted to simple interest.
On a simple interest mortgage, interest is calculated daily instead of monthly. And it is based on the principal balance on the payment day.
For example, a $100,000 home loan at 3.5%, interest per day will be calculated by:
($100,000 x 3.5%) / 365 = $9.59
The amortization table for a simple interest mortgage should reflect that.
Because of how it is calculated and charged to the borrower, should a borrower make extra payments towards the home loan, it will immediately reduce the balance, creating an immediate impact on the interest amount the next day.
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