What is the difference between simple interest versus schedule interest?
Schedule interest is where payments are credited to interest and principal on the due date, whether you pay it a little early or little late. Most lenders use schedule interest method. Your amortization schedule is already fixed since the first day you sign the loan contract.
Simple interest is where the interest portion of the payment depends on the actual number of days that have elapsed since the last payment. If you pay it early, more of your payment is applied toward the principal. If its late, more goes toward interest. If its on time, there is no difference between schedule interest and simple interest. However, if you were offered a bi-weekly payment (meaning your monthly payment is split in half and you pay this amount every 14 days), the savings on a simple interest method is huge!
Take a look at this example:
$100,000 loan with a 10% interest.
Monthly payment is $877.57
With schedule interest calculation (which is used in mortgages), this is how the loan work:
Month 1: $100k x 10% = $10,000 interest
$10k divided by 12 months = $833.33 is 1st month interest
$877.57 - $833.33 = $44.24 goes toward the principal
Month 2: $99,955.76 x 10% = $9,995.576
$9995.576 / 12 = $832.96 is 2nd month interest
$877.57 - $832.96 = $44.61 goes toward the principal
As you can see, it takes a very long time to build equity in your home.
With simple interest calculation (which is used in student loans) and you pay every 14 days, this is how the loan work:
Month 1 (day 1 - 14): $100k x 10% = $10,000 interest
$877.57 divided by 2 = $438.79 bi-weekly payment
$10k divided by 365 days = $27.40
$27.40 x 14 days = $383.60 (first 14 day interest)
$438.79 - $383.60 = $55.19 is applied toward principal
Month 1 (day 15-28): $99,944.81 x 10% = $9994.481
$9994.481 / 365 = $27.38
$27.38 x 14 = $383.32 (second 14 day interest)
$438.79 - $383.32 = $55.47 is applied toward principal
Month 1 summary: Your total payment from day 1-28 is $877.58. $766.92 is interest payment and $110.66 is applied toward principal.
Month 1 - 2 (day 29 - 42): $99889.34 x 10% = $9988.934
$9988.934 / 365 = $27.37
$27.37 x 14 = $383.18 (third 14 day interest)
$438.79 - $383.18 = $55.61 is applied toward principal
Month 2 (day 43-56): $99,833.73 x 10% = $9983.373
$9983.373 / 365 = $27.35
$27.35 x 14 = $382.90 (forth 14 day interest)
$438.79 - $382.90 = $55.89 is applied toward principal
Month 2 summary: $766.08 is interest payment and $111.50 is applied toward principal.
Eventually, the bi-weekly payment plan with simple interest will pay this 30 year loan off sooner by a few years than a traditional mortgage that uses schedule interest.
So far, I have found only one company that use simple interest in debt payments and that is Citicorp Trust Bank, who only deals with Primerica Financial Services' clients. If you are serious about paying your mortgage off faster, I recommend checking out Primerica. When it comes to repaying your debt, there are three questions you should ask yourself before considering to refinance or consolidate:
1) What is my total cost?
2) When will this debt be paid off?
3) What is my interest rate?
The financial industry knows that interest rates is what gets people attention and its a great way to attract new business. What most people forget is that interest rate really doesn't do anything for you. All interest rate does is set the fix payment for the life of the loan. Higher interest rate means higher monthly payment. Lower interest rate means lower monthly payment. Interest rate does not help you pay off the loan faster. Its the rate at which you pay, meaning how fast you pay, that determines your total cost and how soon you will be out of debt. If one bank offers a 6% interest on your mortgage and your current mortgage has 8%, you better ask yourself the first two questions before getting all excited. If you look at all the other people who fall into the interest rate advertisement, all it did is put these people back into longer debt and costing them more in total interest.
