In a NutshellWhen comparing loan options, ask your lender about a simple interest loan. Compared to other types of loans, simple interest loans can help you save money since interest is based on your current principal.
When evaluating your loan options, it’s wise to carefully review the loan terms and disclosures to find out if the loan uses simple, compound or precomputed interest.
The type of interest the loan uses can affect your total repayment cost. Understanding how each interest type works can help you make an informed decision when shopping for a loan.
- How a simple interest loan works
- How simple interest is different from precomputed and compound interest
- Key benefit of simple interest loans
- Potential drawbacks of simple interest loans
How a simple interest loan works
When you take out a loan, you typically have to repay it with interest — the price the lender charges you for borrowing money. Interest rates are usually expressed as a percentage over a set period of time.
Simple interest is calculated and assessed by multiplying the account’s current principal amount (and only the principal) by the interest rate. But as you pay down your principal with each monthly on-time payment, that principal decreases, lessening the interest assessed. And if you pay more than the minimum required payment, the principal will decrease even more.
Here’s an example. Let’s say you took out a simple interest loan of $10,000 with a 5% fixed interest rate and five-year repayment term. Instead of paying 5% on the total $10,000 amount you borrowed, that 5% would be calculated anew each month and spread out across your entire repayment term. Your interest is freshly assessed against your current month’s outstanding principal, which decreases as you make your payments on time, and then recalculated again to be spread out across your total payments. In this example, if you made your minimum payment on time each month, which continually decreases your principal, you’d pay $1,322.74 in interest over the life of the loan, or $188.71 a month. Here’s how that breaks down.
With your first payment, a little less than $42 — or roughly 22% of your payment — would go toward interest. But with your final loan payment, just 78 cents would go toward interest. Let’s take a look at how you would pay down your principal each year with this loan. Remember, this is just one example. When you’re looking into loans, it’s good to ask the lender how your payments will be divided between interest and principal repayment. It’s also important to consider any fees or charges not considered to be interest that may affect your monthly payment.
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You can use our simple loan calculator to find out how much you’d repay over the life of your simple interest loan.
How simple interest is different from precomputed and compound interest
As the name implies, simple interest loans make it relatively easy to calculate interest. It’s frequently used for certain loan types to calculate your repayment costs.
But not all loans are calculated using simple interest. Depending on the type of loan or credit you get, you may be charged precomputed or compound interest instead.
- Precomputed interest — With a precomputed loan, the interest is determined at the start of the loan — rather than as you make payments — and rolled into your loan balance. This means that even if you pay off the loan early or make more payments toward your principal, you won’t get the same reduction in interest charges that you would if your loan had a simple interest plan. On the flip side, late payments on a precomputed loan may not increase the amount of interest you pay — but you could still face late-payment fees.
- Compound interest — For borrowers, compound interest means interest is calculated on your unpaid balance as well as previous unpaid interest charges. Compound interest is what can cause the revolving balance on your credit cards to balloon over time, causing you to repay far more than you initially borrowed.
Key benefit of simple interest loans
A key benefit of simple interest loans is pretty straightforward: You could potentially reduce the total interest over the life of the loan. Here’s how:
- Pay more than the minimum payment (the overage typically goes toward your principal)
- Make additional lump sum payments toward your principal whenever you can
- Pay the loan off early — assuming your loan has no prepayment penalty
Doing any of the above could save you some money — combining all three could significantly reduce the interest you pay on a simple interest loan.
Potential drawbacks of simple interest loans
While you could potentially save money in interest with a simple interest loan, making a late payment could result in more interest, which could set you back.
If you make a late payment — even just one day behind schedule — a greater portion of your payment may go toward interest. This can affect your loan schedule, potentially adding more time to pay off your loan. Depending on your loan terms, you might also be charged a late fee, which could add to the total cost (including interest) of your loan.
And there may be fees added to your loan that don’t count as interest but potentially raise the amount you owe each month. So it’s crucial to keep potential fees in mind when discussing options and costs with a lender.
Choosing a simple interest loan could save you money. But make sure you carefully review the loan terms and disclosures to ensure you understand how interest is calculated, how much your total repayment cost will be, and what additional fees may apply. If you don’t understand any of the details, talk to your lender about the fine print to prevent any misunderstandings. And once you’ve signed on for a simple interest loan, make any additional payments toward the principal that your budget allows to save money over the life of the loan.