What do first and second home mortgage loans, retail installments, automobile loans, home improvement loans and mobile home loans all have in common — aside from being loans to consumers? They all have an interest charge that is sometimes calculated monthly and sometimes daily.
With a monthly interest rate (MIR), the borrower is charged for each month, while with a daily interest rate (DIR), the borrower is charged for each day.
What’s the difference?
The distinction is important because DIRs are a potential trap for unwary borrowers, countless numbers of whom have found themselves permanently indebted, usually with no understanding of how it happened. The problem has been entirely overlooked by regulators, including the Consumer Financial Protection Bureau (CFPB).
As an example, consider a 30-year loan for $100,000 with a rate of 6 percent. The monthly payment for both a MIR and a DIR would be $599.56, part of which pays the monthly interest charge, with the remainder allocated to principal.
To calculate the interest charge on a MIR, the annual interest rate is divided by 12, then multiplied by the balance at the end of the preceding month to obtain the interest due for the present month. If the loan balance on the 6 percent MIR is $100,000, the interest is .06/12 x 100,000 = $500. The principal is 599.56 – 500 = 99.56.
With a DIR of the same amount and same annual rate, the daily interest is .06/365 x 100,000 = $16.44. The interest due for the month is then 16.44 x 30 = $493.3 or 16.44 x 31 = $509.64, resulting in principal of 106.56 or 89.92, depending on whether the month has 30 or 31 days.
Treatment of late payments
The payment due date is usually the first business day of the month for both MIRs and DIRs. The critical difference between them is their treatment of payments that are posted later on. MIRs 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 DIR, daily interest accrual never stops. If the borrower pays on the first day of a month following a month that has 30 days, he or she owes 30 days of interest. If the borrower pays on the fifth day of the month, he or she will owe 34 days of interest.
It also works in the other direction. If the borrower pays before the due date, say on the 25th day of the preceding month, he or she will owe only 25 days of interest.
It follows that a DIR is much more challenging for borrowers than a MIR. Those who are disciplined and understand how it works can sometimes use it to their advantage, but they are very few. Most borrowers who have a DIR do not know it, and their ignorance often costs them dearly. Many of those with less-than-pristine payment habits can find themselves on a slippery slope toward permanent indebtedness.
The slippery slope of a DIR
Consider the DIR referred to earlier with an annual rate of 6 percent. You have a mortgage payment of $599.56, a 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, his or her payment to principal will be 599.56 – 509.64 = 89.92.
But for each day the borrow is late, the interest charge rises and the payment to principal declines by $16.44. If the borrower is six or more days late, the interest charge will now exceed his monthly payment, so instead of a payment towards the principal, the lender will record an “interest deficit.”
The borrower is now on a 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 slope is steeper at higher rates
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.
DIRs are not inherently flawed
In a market where borrowers were offered a MIR and a DIR and understood the features of both, those who could make payments at regular intervals shorter than 30 days — every 28 days, for example — would select a DIR.
Everyone else would select a MIR unless they were enticed to accept a DIR in order to get a lower interest rate. But that is not the market we have.
Borrowers have no choice
I have never encountered a case where borrowers were given the choice between a MIR or a DIR. Invariably, they accept what is offered without realizing there is an issue.
I know of many cases where borrowers initially had a MIR but were switched to a DIR by another lender after their loans were sold. Such a switch must be permitted by the note, which has been the case with each one I have examined.
The problem is that notes are silent on how the interest charge is calculated.
I was approached last week 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 a DIR: 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: in a document called “Type of mortgage,” there was a checked box called “Simple interest,” which is the code name for a DIR. But the dictionary tells us that simple interest means that interest is not paid on interest. And it is true that on the DIR, interest is not paid on the interest deficit, but almost all MIRs are also simple interest.
The only MIRs I know of that permit interest compounding are the toxic option ARMs that were written before the financial crisis (but not since). The sole reason to describe a DIR 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 DIR, the interest rate the borrower actually pays is the daily rate, and that is not shown because doing so could give the game away.
Lurking in the shadows is the question of whether a 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 they don’t offer 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 or 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 a DIR are bound to be greater than those on a MIR.
The CFPB was created to protect consumers, with a major focus on loan disclosures, which it took over from HUD and the Federal Reserve. Redesigning the disclosure forms was a major priority.
Its new Loan Estimate designed for shoppers and its Closing Disclosure for borrowers are larger and clearer than the documents it replaced, but neither shows whether interest is calculated daily or monthly. This is shameful.
I am told by reliable sources that FHA 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.
Jack M.Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania and author of The Mortgage Encyclopedia.