There are many financial artifices that effectively convert compound to simple interest. One such technique is to structure a series of annual Notes secured by a single mortgage. Each will contain an agreed upon interest rate, but each will become effective and start earning interest in a sequential time period.
In the above example, if you carried back $100,000 financing on a home sale for 10 years, I'd give you ten $10,000 Notes, each dated and falling due in successive years. Each might contain a stated interest rate of 10% per annum. Thus, each year, I'd pay $11,000 including principal and interest to pay off each note.
At the end of 10 years, you'd have received $110,000, or 10% return on your loan, just as promised. But, had this been a single $100,000 note payable in ten annual payments at 10%, the payments would have been $16,274.54. Over 10 years you would have received $52,745.39 more.
We'll leave this subject for now with a final concept. Suppose I signed a ten year $100,000 Note that called for 10% interest, but in the portion where our seller's carry back note language might have called for payments to be first applied to interest, in this note, we'll specify that payments first must be credited toward principal. Let's see what would happen:
Year Payment Unpaid Principal Balance Interest Accrued Interest
1 $11,000 $89,000 $8,900 $ 8,900
2 $11,000 $78,000 $7,800 $16,700
3 $11,000 $67,000 $6,700 $23,400
4 $11,000 $56,000 $5,600 $29,000
5 $11,000 $45,000 $4,500 $33,500
6 $11,000 $34,000 $3,400 $36,900
7 $11,000 $23,000 $2,300 $39,200
8 $11,000 $12,000 $1,200 $40,400
9 $11,000 $ 1,000 $ 100 $40,500
10 $ 40,500 – 0 – – 0 – – 0 –
It's possible that the last balloon payment might be refinanced with another loan structured the same way. Let's look at the same loan if it had been structured with the same term and payments, but with payments being applied first to interest rather than to principal.
Payment Unpaid Principal Balance Interest Paid Princ. Paid
1 $11,000 $100,000 $10,000 $1,000
2 $11,000 $99,000 $9,900 $1,100
3 $11,000 $97,900 $9,790 $1,210
4 $11,000 $96,690 $9,669 $1,331
5 $11,000 $95,359 $9,536 $1,464
6 $11,000 $93,895 $9,390 $1,610
7 $11,000 $92,285 $9,228 $1,772
8 $11,000 $90,513 $9,051 $1,949
9 $11,000 $88,564 $8,856 $2,144
10 $86,420 – 0 – – 0 – $86,420
You can readily see that with identical payments, interest rate, and terms, by applying payments first to principal, $45,920 in interest costs are thus saved. As a borrower, why wouldn't you structure all your mortgage payments this way?
