The interest involved in a mortgage is calculated based on the mortgage’s amount as a percentage. If you have an adjustable-rate mortgage, the interest you would pay can either increase or decrease based on market indexes. Meanwhile, if it’s a fixed-rate mortgage, the interest will remain the same throughout the loan.
Knowing that, what type of interest are mortgages? Are they simple or compound? That’s exactly what we’re going to talk about. We are going to answer the question, are mortgages compound interest?
In this article, we will cover the following topics to answer are mortgages compound interest?
What Type of Interest are Mortgages?
Some people say that mortgages are simple interest, though others would claim that they’re compound. In the US, however, mortgages are considered simple interest as they’re not compounded. As such, you don’t have to pay interest which is added to your outstanding balance every month.
This simply means that as a simple interest, mortgages:
- Are not compounded
- Don’t involve paying interest on top of interest
- Are paid over the lifetime of the loan
- Have their interest pre-determined
In order to better understand mortgage interest, let’s first have a look at what simple and compound interests are and their characteristics.
In a simple interest mortgage, the interest in the first period won’t affect the interest in the second period. For example, if you have a $100,000 simple mortgage loan with a 5-year term at 1% annual interest, then you can expect to pay $1,000 every year on interest for a total of $5,000.
If the annual interest rate is at 2%, then the total interest would be $10,000 which is exactly twice that of the 1% loan. Meanwhile, if the rate is still at 1% a year but the loan has a 10-year term, then the total interest also doubles. Specifically, you just have to multiply the loan principal by the rate and duration to get the total interest.
In a compound interest mortgage, however, your unpaid interest by the end of the first period will be added to the principal for the second period. This causes the interest to compound. Using the same example above, if you have a $100,000 loan with a 5-year term at a 1% compound interest rate, then the interest for the first year will be $1,000, the second year $1,010, the third year $1,020.10, the fourth year $1,030.30, and the fifth year $1,040.60, resulting in a total of $5,101.
At a 2% annual interest, the total interest would be $10492.14 which is more than twice that of a 1% mortgage loan, thanks to compounding interest. That said, the higher the rate or the longer a compound interest’s term is, the higher the interest you’ll have to cover compared to simple interest.
In a traditional home mortgage, your monthly payment will cover that month’s interest while the remaining is then applied to the principal. The interest won’t add to the principle for the other months. Therefore, we can arrive at the conclusion that a mortgage isn’t really a simple interest but a compound interest that doesn’t compound. The reason is that the interest for each month is paid in full, so nothing will compound in the succeeding months.
On the other hand, if a mortgage is interest-only, it will act exactly like a simple interest mortgage. Hence, if it has twice the interest rate, the total interest for every period and the entire lifetime of the loan will be doubled.
Why is Mortgage a Compound Interest that Doesn’t Compound?
There’s that thing called mortgage amortization which makes paying down principal even trickier. Despite the fact that interest won’t carry over from one month to the next – and even if you’re not charged higher the next month in the event you skip a payment – the loan will no longer behave as simple mortgage interest.
By doubling interest rates, a loan’s total interest will be more than double over its lifetime. This means that for a 30-year mortgage at 8% interest, you’ll end up paying more than 2.3 times compared to a 30-year mortgage at 4%. The same applies when the loan’s term is doubled.
By making a principal payment ahead of time, you’ll be creating a compounding effect. For example, if you pay an extra $1,000 in month 13, you’ll end up not having to pay interest for that $1,000 but also cause your next regular payments to go toward the principal amount. This, in turn, results in the reduction of your total interest.
It is for this reason why traditional mortgages with amortization schedule can be considered compound interest but not necessarily one. Their compounding effect is basically from their varying principal payments instead of the compounding interest which is what compound interest loans are known for.
Meanwhile, if your principal payments are the same between two mortgages, then they will act like simple interest. If your principal payments remain the same by making extra payments on an 8% mortgage loan, its interest will be exactly twice that of a 4% loan but not more than that. That’s exactly how simple interest loans behave.
Are Mortgages Compounded on a Monthly Basis?
As mentioned earlier, traditional mortgages don’t compound interest. Therefore, you can expect that there will be no monthly compounding. They are, however, calculated on a monthly basis, allowing you to determine the total interest by multiplying the outstanding balance by the interest rate then dividing the answer by 12.
So for example, if you have a $300,000 balance multiplied by 2% then divided by 12, that would be $500 per month which is just the interest portion. Meanwhile, the $609 in principal will be the remaining portion which reduces your outstanding balance to just $299,391.
You can use amortization calculators in order to have an idea of how the figures are obtained. One good example is this one.
In the next month, the same equation applies. Taking the calculated balance of $299,391 and multiplying it by 4% then dividing by 12, you would get a total interest of only 499. Since monthly payment is fixed, only the principal payment will increase – this time, it’s at $610. This means that a month’s interest due is calculated monthly, not daily, so you shouldn’t worry too much about when to pay your mortgage given that it’s within the grace period.
Most of the time, mortgage lenders will allow repayment of the previous month by the 15th of the current month without any penalty, even if it’s already due on the first of the month. This is because, as mentioned, interest is calculated on a monthly basis.
To make things even more complicated, as what the mortgage industry does best, you can find “simple interest mortgages” which have their interest calculated daily. Therefore, instead of calculating your interest due by dividing it by 12, you divide it by 365 instead.
They’re not really that common in the market, but if you do happen to find one, then you really have to pay attention to the exact payment date since interested is calculated on a daily basis. If you failed to pay on time and make the payment a day later, it will end up costing you more. Fortunately, most mortgages are calculated monthly, so that shouldn’t be too much of a concern.
A Notable Exception
By now, you’ve already known that mortgages are calculated monthly but don’t have any compounding interest. However, there is actually one exception to this: the negative amortization loan.
Basically, a negative amortization loan will compound interest if ever you make minimum payments. One such example is the once-popular adjustable-rate mortgage (ARM), likewise known as a pick-a-pay mortgage.
This type of mortgage loan features negative amortization which causes the interest to compound. Generally, an ARM’s interest rate will fluctuate based on current market trends. Most of the time, however, you will get a certain term at the beginning of the loan period wherein the interest is still fixed.
ARM does it so since borrowers have the option to pay less than their total interest due for the month. This results in a deficit to their outstanding balance. Therefore, a borrower who opted for an adjustable-rate mortgage will end up paying interest on top of interest in the next months if he keeps on paying his interest due in lesser amounts.
Luckily, this option isn’t very common these days, though it’s a good exception to a mortgage which is classified as compound interest.
Final Thoughts on Are Mortgages Compound Interest?
Traditional home mortgages are still considered simple interest despite behaving like compound interest. Their only compounding features are from the varying principal payments. However, if you don’t vary the principle payments (like going for a zero principal payment instead), then the interest won’t compound.
Unfortunately, a lot of people tend to get confused on this one. Technically, a mortgage’s interest doesn’t compound, only its principal payments. So a $1,000 principal payment will save interest on that amount, causing the next principal payments next year to increase, and so on until both principal payments and interests become zero.
Despite mortgage not being an actual compound interest, you’re better off treating it as one. After all, lowering the rate will produce a compounding effect, and so will shortening the term and pre-paying the principal, allowing you to easily repay your mortgage loan.