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Don Taylor, Ph.D., CFA, CFP   Expert: Don Taylor, Ph.D., CFA, CFP
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Simple-interest loans follow own rules

Dear Dr. Don,
What's the difference between a simple-interest loan and a scheduled-interest loan on a mortgage or car loan?
-- Marco Mortgage

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Dear Marco,
With a standard mortgage or car loan, interest is calculated in arrears and there is a grace period on the loan. Every payment has a month's worth of interest. Paying early or within the grace period doesn't influence the interest expense.

With a simple-interest loan, interest is calculated on a daily basis and the interest expense accumulates in a separate account. Loan payments go first toward paying off the interest, then any remaining funds are used to pay down the loan balance.

If you pay 10 days after the payment due date, you'll owe an additional 10 days interest and less money will go toward paying down the loan. Paying early on a simple-interest loan will reduce the interest expense and increase the amount of money going toward paying down the loan.

The Mortgage Professor, Jack Guttentag, tackles the difference between the two types of interest in greater detail on his Web site, mtgprofessor.com. It's worth a look.

Bankrate.com's corrections policy -- Posted: Nov. 6, 2007
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