Understanding How Mortgage Interest Rates Work

Question: What do home mortgage loans (including second mortgage loans), retail installment loans, automobile loans, home improvement loans, and mobile home loans, have in common — aside from being loans to consumers?

Answer: The interest charge sometimes is calculated monthly and sometimes daily. With a monthly interest rate the borrower is charged for each month, whereas with a daily interest rate the borrower is charged for each day.

Why is this distinction important? Because daily rates are a potential trap for unwary borrowers, countless numbers of whom have found themselves permanently, usually with no understanding of how it happened. The problem has been entirely overlooked by regulators, including the Consumer Financial Protection Bureau.

Consider an example: a 30-year loan for $100,000 with a rate of 6 percent. The monthly payment for both a monthly rate and a daily rate would be $599.56, part of which pays the monthly interest charge, with the remainder allocated to principal. To calculate the interest charge on an monthly rate, the annual interest rate is divided by 12 and then multiplied by the balance at the end of the preceding month to obtain the interest due for the month. If the loan balance on the 6 percent monthly rate is $100,000, the interest due for the month is (0.06 / 12) times $100,000 = $500. The principal is the payment amount of $599.56 minus the interest of $500.00 equaling $99.56 — the amount that your remaining balance is reduced by.

With a daily rate of the same amount and same annual rate, the daily interest is (0.06 / 365) times $100,000 equals $16.44. The interest due for the month is the $16.44 daily rate times 30 days to equal $493.3 in interest — or in a 31-day month $16.44 times 31 equals $509.64 — resulting in principal repayment of $106.56 or $89.92, depending on whether the month has 30 or 31 days.

The payment due date is usually the first business day of the month for both monthly rates and daily rates. The critical difference between them is their treatment of payments that are posted after the due date. monthly rates typically have a payment grace period of 10 to 15 days, during which the lender will accept the monthly payment as payment in full. Borrowers are subject to a late charge only if their payment is posted after the grace period has expired.

On a daily rate, daily interest accrual never stops. If the borrower pays on the first day of a month following a month that has 30 days, she owes 30 days of interest. If she pays on the fifth day of the month, she will owe 34 days of interest. But it also works in the other direction. If the borrower pays before the due date, say on the 25th day of the preceding month, she will owe only 25 days of interest.

It follows that daily rates are much more challenging for borrowers than monthly rates. Disciplined borrowers who understand how it works can sometimes use it to their advantage, but they are very few. Most borrowers who have daily rates do not know it, and their ignorance often costs them dearly. Many of those with less than pristine payment habits find themselves on a slippery slope toward permanent indebtedness.

The Slippery Slope of a Daily Interest Rate
Consider the daily rate referred to earlier with an annual rate of 6 percent, a mortgage payment of $599.56, daily interest of $16.44 and total interest due for a month with 31 days of $509.64. If the borrower pays on the due date, her payment to principal will be $599.56 – $509.64 = $89.92. But for each day she is late, the interest charge rises and the payment to principal declines by $16.44. If she is six or more days late, the interest charge exceeds her monthly payment, so instead of a payment to principal, the lender records an “interest deficit.”

The borrower is now on the slippery slope because the interest deficit is added to the interest charge due the following month. So long as the borrower has an interest deficit, the loan balance remains unchanged.

The higher the interest rate, the quicker is the emergence of an interest deficit. At 3 percent the borrower has 20 days to avoid a deficit, at 6 percent she has five days, and at 12 percent she has one day.

The trap closes most quickly on the weakest borrowers who pay the highest rates.

In a market where borrowers were offered both monthly rates and daily rates, and prospective borrowers understood the features of both, those who could make payments at regular intervals shorter than 30 days — every 28 days, for example — would select daily rates. Everyone else would select monthly rates unless they were enticed to accept daily rates in order to get a lower interest rate. Daily rates would be priced lower. But that is not the market we have.

I have never encountered a case where a borrower was offered the choice of monthly rate or daily rate. Invariably they accept what they are offered, without realizing there is an issue.

I have encountered many cases where borrowers initially had an monthly rate that was switched to daily rate by another lender after their loans were sold. Such a switch must be permitted by the note, which has been the case with every note I have examined. Notes are silent on how the interest charge is calculated.

Misleading Documents
Last week I was approached by a lady who had purchased a manufactured home in 1998 for $39,000 and financed it with a retail installment contract at 12 percent. Her concern was the usual one that arises with daily rates: After 20 years, she owed almost as much as she had borrowed. No one had ever explained the perils of daily interest to her.

The documents she was given at origination had only one clue. On a document called “Type of Mortgage” there was a checked box called “Simple Interest.” That is the code name for a daily rate. But the dictionary tells us that simple interest means that interest is not paid on interest. And it is true that on the daily rate, interest is not paid on the interest deficit. But almost all monthly rates are also simple interest. The only monthly rates I know of that permit interest compounding are the toxic option ARMs that were written before the financial crisis but not since. The only reason to describe a daily rate as a simple interest loan is to obfuscate its central feature.

The interest rate shown on the origination documents is the annual rate, which is used in calculating the monthly payment. But on a monthly rate the interest rate the borrower actually pays is the daily rate, and that is not shown. Showing the daily rate could give the game away. Lurking in the shadows is the question of whether that rate is calculated using a 365-day year or a 360-day year. There is no way to know.

The servicing statements the borrower receives perpetuate the obfuscation. They show the interest charges that have accrued but not a clue as to how the charges are calculated.

Where are the federal agencies? With one exception, they ignore the issue. The pricing schedules and underwriting requirements of Fannie Mae and Freddie Mac do not distinguish between mortgages charging monthly interest and mortgages charging daily interest. The agencies purchase both subject to the same requirements and the same prices. This is difficult to rationalize because the loss rates on daily rates are bound to be greater than those on monthly rates.

The Consumer Financial Protection Bureau was created to protect consumers, with a major focus on loan disclosures, which it took over from the Department of Housing and Urban Development and the Federal Reserve. Redesigning the disclosure forms was a major priority. Its new Loan Estimate designed for shoppers and Closing Disclosure for borrowers are larger and clearer than the documents they replaced, but neither shows whether interest is calculated daily or monthly. This is shameful.

I am told by reliable sources that the Federal Housing Administration will not insure a daily interest mortgage, so they are evidently the exception, but I have not been able to confirm this.
Next week: How to fix this festering sore.

About the Writer
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.

Source: mortgagedaily.com