I recently had a life insurance sales person come by go through a whole presentation on saving money. Part of the presentation was a sample person paying something like 7% for a conventional home loan. He then showed how the person was able to pay the house off in half the time with a simple interest rate loan at 4%. The obvious problem with this scenario is the different interest rate. Obviously if you drop the interest rate significantly you’re going to save a lot of money per month or be able to pay your house off faster.
Let’s say I have a $150,000 mortgage at 7%. With a conventional loan (which uses compound interest) the monthly payment is $997.95. If I get a 4% interest rate the payment goes down to $716.12. A savings of over $280 dollars per month. Now, let’s pay off that 4% loan with the 7% payment. The loan will be paid off in 17 and a half years instead of 30. Total interest paid is $54,580.
Now, let’s switch to a simple interest loan at 4%. 4% of $150,000 is $6000 of interest. Banks calculate the daily interest for simple interest by dividing the yearly interest by 360. So the daily interest is $16.67. The simple interest daily rate never changes so the math is very simple. We want to pay off our loan in 17 and a half years. That’s 365*17 + 365/2 days or about 6387 days. Which is about $106,471 worth of interest. That’s nearly twice the amount of interest we would have paid had we gotten a conventional loan with a 4% interest rate.
Our original loan at 7% for 30 years would have cost over $209,000 in interest. So the simple interest loan at 4% cuts the interest nearly in half. But now let’s see what our payment would be on a simple interest loan that we pay off as quickly as we could pay off a 4% conventional loan.
We have $106,471 in interest to play plus the $150,000. So in total we have to pay $256,471 off in 17 and a half years. That requires a payment of $1221.29 a month. More than $200 more than our original payment. And nearly $500 more per month than a compound interest loan at 4%.
Compared to a 7% 30 year conventional loan the 4% simple interest loan looks like a great deal. The only way a simple interest loan saves you money is by having a much lower interest rate and having a much lower pay off time. And no matter what, a comparable compound interest loan will beat a simple interest loan by a significant amount.
So in conclusion, if someone tries to sell you a simple interest rate loan, make them compare it to a compound interest rate loan with the same interest rate. Then tell them to get lost.
