Anytime you borrow money from a financial institution, you will have to pay interest. A simple interest loan is a type of loan where the principal amount determines the interest rate. Your lender will charge interest daily on the principal balance, between each payment. There are also precomputed interest rates and compound interest to consider with loan options. When borrowing money, it is essential to familiarize yourself with the different interest options that exist. Below is more information on a simple interest loan and calculating interest amounts on one, along with more details on its counterparts.
How Do Simple Interest Loans Work Exactly?
As mentioned above, a simple interest loan calculates the interest based on the principal balance, charged daily between monthly payments. In case you are unsure, the principal amount is the amount you initially borrowed from your lender.
To help you get a better understanding of exactly how these loans work, here is an example:
Suppose you take out a simple interest loan for $5,000 with an annual interest rate of 23%, and your first monthly payment is due in 30 days. From here, you will need this formula which you can use to calculate simple interest:
The principal amount (P) x the daily interest rate (I) x the number of days in between payments (N)
P x I x N
5,000 x (0.23/365) x 30 = 94.52
$94.52 is only your interest payment, any more than will go towards paying off the principal. For example, let’s say your monthly minimum payments are $200. For your first payment, $94.52 will go towards interest, and $105.48 will go towards the principal balance. So your new principal amount will be 4,894.52, which you can then use to calculate your next payment and so on.
Common Examples of Simple Interest Loans
Most simple interest loans will be short-term; however, there can definitely be exceptions. Here are some common examples of simple interest loans:
- Short Personal loans.
- Car loans.
- Sometimes payday loans.
- Retailer installment loans.
- CDs, although not a loan, collect simple interest.
- Sometimes a mortgage payment is calculated in simple interest terms.
Pros and Cons of a Simple Interest Loan
There can be a good amount of benefits and some drawbacks that come with simple interest loans. Here are the pros and cons when you pay interest this way:
Some Advantages of a Simple Interest Loan
- You can pay less interest if you pay off the loan early, which may be a better strategy than just focusing on on-time payments.
- The lender charges interest only on the principal balance, not the interest you acquire during the loan.
- You can pay off these loans early, usually without penalties.
Some Disadvantages of a Simple Interest Loan
- Late payments can mean paying more interest, making the loan more expensive.
- Finding a simple interest loan may be challenging, as not all lenders offer this kind of funding.
- Because interest is calculated daily, there may not be a grace period for late payments.
How Are Simple Interest Loans Different From Compound and Precomputed Loans?
Now that you know the basics of simple interest loans, it will also be helpful to look at other ways lenders charge interest. Here are the two other main interest types you will come across when researching loan options:
A Compound Interest Loan
A compound interest loan collects interest on both the principal and the loan interest amount. Many credit card balances or revolving accounts have a compounding interest rate. The interest calculated will depend on the loan term your lender gives you.
For example, the interest may be compounded annually, or there may be multiple periods within the year where interest is charged—called compounding periods. Because the interest owed will be determined by both principal and interest, the amount of compounding periods will significantly impact the cost of the loan.
A Precomputed Interest Loan
A precomputed interest loan is the most simple of the three different types. With these loans, you don’t have to worry about calculating interest because you will know exactly how much interest you will be paying each month. When you take out the loan, your lender will let you know how much the annual percentage rate (APR) and the monthly percentage rate (MPR) will be. From here, you will have steady monthly payments until you pay off the loan.
Simple interest loans acquire interest daily in between payments. One of the most common examples are auto loans. The great thing about simple interest loans is that you can save money if you make your monthly payments early. Along with that, interest occurs only on the principal balance, not the interest rate. If you miss a payment on one of these loans, you could be paying much more than you need! Before taking out any loan, reviewing and calculating the interest rate, going over loan terms, and researching the lender are all important.