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When considering your loan options, knowing the type of interest charged on the loan is just as important as knowing the interest rate.
There are three common types of loan interest: simple interest, compound interest and precomputed interest. It’s important to know how interest is calculated on a loan before you sign a contract, because it can affect how much total interest you pay.
Let’s take a look at how a simple interest loan works, and how this type of interest differs from compound and precomputed interest.
How a simple interest loan works
With a simple interest loan, interest is calculated based on your outstanding loan balance on your payment due date.
With installment loans, you’ll generally have a fixed repayment term. When you make a payment, some of it goes toward the interest charges, while the rest is applied to the loan principal. At first, more of your monthly payment will typically go toward the interest. Over time, more of your monthly payment will go toward the principal as you pay down the loan balance.What is the average interest rate on a personal loan?
For example, let’s say you took out a $10,000 loan with a 5% interest rate and five-year repayment term. With a simple interest loan, your monthly payment would be $188.71, assuming your interest rate doesn’t change over the life of the loan. If you made your minimum payment on time each month, you’d pay $1,322.74 in interest over the life of the loan.
With your first payment, just under $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.
Key benefit of simple interest loans
A key benefit of simple interest loans is that you could potentially save money in interest.
With a simple interest loan, you can typically reduce the total interest you pay by …
- Making more than your minimum monthly payment toward your principal
- Making extra payments toward your principal
- Paying the loan off early — assuming your loan has no prepayment penalty
A potential drawback of simple interest loans
While you could potentially save money in interest with a simple interest loan, making a late payment could result in your paying 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 of your loan.
How simple interest is different from precomputed and compound 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 will not get the same reduction in interest charges that you would if your loan had a simple interest rate. 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.
If you make on-time payments for the full term of a precomputed loan, you’ll generally pay about the same in interest as you would on a simple interest loan.
Compound interest can be a more expensive way of calculating interest. With a compound interest loan, interest is added to the principal — on top of any interest that’s already accumulated.
A compound interest loan will usually cost you more in interest than a simple interest loan with the same annual percentage rate.
Whether you’re shopping for a personal loan, car loan or mortgage, opting for a simple interest loan could save you money. If you apply for and get prequalified from multiple lenders, you can get an idea of what might be the best loan for your situation. But prequalification won’t guarantee approval for a loan.
Before you apply for a loan, make sure you read the fine print thoroughly to understand how the interest is calculated — and ask your lender questions if you don’t understand any of the information provided.Tips for prequalifying for a personal loan