Mortgage Professor: “Daily Interest: A Festering Sore in Consumer Loan Markets”

Posted on by Phil Querin

[Jack M.Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania and author of The Mortgage Encyclopedia. Throughout his career, Professor Guttentag has been concerned with the difficulties faced by consumers in the home loan market.]

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 (MIR), the borrower is charged for each month whereas with a daily interest rate (DIR) the borrower is charged for each day.

Why is this distinction 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.

An Example:

Consider a 30-year loan for $100,000 with a rate of 6%. 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 an 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 month. If the loan balance on the 6% MIR is $100,000, the interest due for the month is .06/12×100, 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 .06/365×100,000 = $16.44. The interest due for the month is 16.44×30 = $493.3 or 16.44×31 = $509.64, resulting in principal of 106.56 or 89.92, depending on whether the month has 30 or 31 days. [MORE: Go to link here.]

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