Are Mortgages Compound Interest?

are_mortgages_compound_interest

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?

ARTICLE CONTENTS:

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.

Simple Interest

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.

Compound 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.

Home Mortgage

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.

This page may contain affiliate links. This website may contain content that comes from Amazon. This website and its pages are not intended to constitute legal, financial, or tax advice. The information on this website and its pages are not intended to constitute investment advice and all content are the views and opinions of the author(s), contributors, or administrators. Please read our disclaimer for more info.

Hi. My Name is

James Gheen

Welcome to the Bigger Investing website. I’m here to help you find the resources, motivation, and guidance for all entrepreneurial, investing, business, career endeavors, and more, so that you can invest in what’s most important. Your mind!

My focus is to equip you with expert sources, books, guides, articles, and more to help you achieve your personal goals.

Want to learn more? Take a look.

getabstract ad


Read in Graphics

Rich Dad Summit Ad

Best Books on Technology Industry

Best Books on Technology Industry

echnology in our society is something that helps us in many ways. It has changed the way we work, communicate, do business, and even how we learn. This blog post will provide you with a list of some great books on the technology industry to help...

What Businesses Use Telemarketing?

What Businesses Use Telemarketing?

elemarketing is a marketing technique that has been in use since the 1930s. It was developed to help businesses and individuals reach out to customers and potential clients by phone. Businesses of all sizes can benefit from telemarketing, but...

How Do I Start a Telemarketing Business?

How Do I Start a Telemarketing Business?

fter you have thought about the potential of a telemarketing business and decided it is for you, there are many steps to take before launching your company. First, find an office space that will suit your needs and then start looking for...

Best Books on Telemarketing

Best Books on Telemarketing

he most important part of a telemarketing campaign is the initial contact. This is where you make your pitch, and to do this effectively, you need to know what script to use. A good book on telemarketing will guide you through every step of the...

What are the Seven Rules of Negotiation?

What are the Seven Rules of Negotiation?

egotiation is a crucial skill to have in any business. It can be used not only with clients but also internally to get the best terms for your company and employees. While there are many different ways to negotiate, some of the most important...

What are Good Negotiation Skills?

What are Good Negotiation Skills?

he ability to negotiate is one of the most essential skills that a person can have. Negotiation is not only important in business, but it's also an important skill in life. The way you negotiate will determine your future success and happiness. A...

What is the Key to Successful Negotiation?

What is the Key to Successful Negotiation?

here are certain things you should never do in a negotiation. When I was just starting out, these were some of the most difficult lessons for me to learn. If you want to be successful at negotiating, there are three basic principles that will help...

How Do You Counter Offer a Salary?

How Do You Counter Offer a Salary?

t can be really difficult to counter offer a salary. When it comes down to it, you want the job and they want you. So how do you turn this situation into an advantageous one? The first thing is to know what your worth is. It may seem like a...

How Do You Start a Negotiation?

How Do You Start a Negotiation?

here are many ways to start a negotiation, but you need to keep in mind that the person on the other side of the table is just as nervous and scared about it as you are. You can make them feel more comfortable by starting with an ice breaker...

What Makes a Good Sales Negotiator?

What Makes a Good Sales Negotiator?

f you're in the market for a good sales negotiator, it's important to know what makes somebody successful at this job. First of all, they have to be able to negotiate well and get their clients the best deal possible. They also need to understand...

What is a Lettings Negotiator’s Salary?

What is a Lettings Negotiator’s Salary?

hat is a lettings negotiator's salary? This question should be on the mind of any prospective rental tenant. The negotiation process can be confusing, and knowing what to expect can help make it less stressful. The first thing to consider is that...

How Do You Deal with a Hard Negotiator?

How Do You Deal with a Hard Negotiator?

f you want to successfully negotiate a deal, it's important that you know how to handle someone who is hard-headed. These people are difficult and will not budge on their prices or demands. In this blog post, we'll discuss strategies for dealing...

What is the Most Important Attribute of a Negotiator?

What is the Most Important Attribute of a Negotiator?

negotiator is someone who helps two parties reach an agreement. What are the most important skills needed for this job? The answer to that question depends on what type of negotiation you're doing. In a business negotiation, it's important to be...

What Are the Characteristics of a Good Negotiator?

What Are the Characteristics of a Good Negotiator?

good negotiator is someone who has the ability to manage their emotions and think strategically. They are also able to communicate well with others, which can lead to building stronger relationships that could be beneficial in future negotiations....

What Country Has the Lowest Capital Gains Tax?

What Country Has the Lowest Capital Gains Tax?

he United States has one of the highest capital gains taxes in the world. It's a whopping 39% on long-term capital gains and 20% on short-term capital gains. If you're looking for a country with lower tax rates, look no further than Estonia. The...

Are There Any Tax Shelters Left?

Are There Any Tax Shelters Left?

here are many different tax shelters, and some of them are more popular than others. One of the most popular is a retirement account such as an IRA or 401k, but there are other options out there. In this blog post, we will explore these...

How Do Billionaires Avoid Taxes?

How Do Billionaires Avoid Taxes?

illionaires have a lot of money and they don't want to pay taxes on it. That seems pretty simple, right? In reality, their tax avoidance is more complex than you might expect. We're going to take a look at the different strategies that...

How Do Tax Havens Make Money?

How Do Tax Havens Make Money?

ax havens are a hot topic these days. They make money by helping businesses, wealthy individuals, and other investors keep their money away from the taxman. This is done in a variety of ways including bank secrecy laws that limit the amount of...

What is Called a Tax Haven?

What is Called a Tax Haven?

tax haven is a country or territory that offers favorable tax rates to foreign individuals, corporations, and other business entities. Tax havens can be either onshore or offshore and are typically characterized by strict banking secrecy laws in...

What is the Benefit of Being a Tax Haven?

What is the Benefit of Being a Tax Haven?

here are many benefits of being a tax haven, which is why so many people are drawn to this type of business. One of the main reasons that businesses choose to move their headquarters offshore is for the purpose of escaping high taxes and...

Is Switzerland a Tax Haven?

Is Switzerland a Tax Haven?

Switzerland is a small, landlocked country located in the Alps. It has been called a tax haven because it does not impose any taxes on personal income or capital gains - but is it really? Switzerland has one of the highest rates of taxation in...

How Can I Live Tax-Free?

How Can I Live Tax-Free?

any people are asking themselves this question. The answer is to move to a state that doesn't have any income taxes or sales tax, and then you will be able to live without having your hard-earned money go towards the government. It's not as...

Where Do the Rich Hide Their Money?

Where Do the Rich Hide Their Money?

he rich have a lot of money, so it is no surprise that they are always looking for ways to protect their assets. However, the question remains: where do they hide their cash? It can be hard to find out what people with a lot of money are doing...

Which Country Has No Tax?

Which Country Has No Tax?

axes are a big deal. In some countries, they cover up to 50% of the GDP. Some people believe that it would be better if there was no tax at all because that means each citizen's earnings will grow faster and more evenly. But which country has no...

Is Dubai a Tax Haven?

Is Dubai a Tax Haven?

he United Arab Emirates is a popular destination for ex-pats and internationals alike. The country has developed rapidly in the last 20 years, becoming one of the wealthiest countries in the world. But there are many who question whether Dubai is...

Are Tax Havens Good or Bad?

Are Tax Havens Good or Bad?

here are many arguments for and against the use of tax havens such as Switzerland, Luxembourg, or Barbados. Proponents argue that they are essential to free trade by protecting investments from taxation in other countries. Opponents claim it is a...

How Does a Tax Havens Work?

How Does a Tax Havens Work?

tax haven is a country with nominal taxes that have low or zero taxation on certain types of income. These countries typically offer favorable regulations for businesses and individuals to help them attract more capital. Tax havens can be used as...

Which Country is the Best Tax Haven?

Which Country is the Best Tax Haven?

he tax havens are a legal way of hiding money from the IRS. They allow people to put their wealth in offshore accounts, which don't have to be reported on any taxes until they're withdrawn. The United States government has been trying for years to...

Are Tax Havens Legal?

Are Tax Havens Legal?

ax havens are a controversial topic. Some people believe that tax havens are illegal, while others think they can be legal. In this article, we will explore the legality of tax havens to help you make an educated decision about whether or not it...

Best Books on Tax Havens

Best Books on Tax Havens

he best books on Tax Havens is a list of some of the most popular and reputable books that can help you learn about how to reduce your taxes by taking advantage of countries with low or no taxation policies. Whether you want to find out about the...