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.
Anytime you borrow money from a financial institution, you will have to pay interest. The interest rate differs depending on the type of loan and the lender. However, the average personal loan interest rate is 10.82%.1
When borrowing money, it is essential to familiarize yourself with the different interest rates to understand the true cost of borrowing. 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 to calculate how you pay interest:
The principal amount (P) x the daily interest rate (I) x the number of days in between payments (N).
Or simply, 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 quick cash loans
- Car loans
- 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. Below are the pros and cons of simple interest loans.
| Pros of Simple Interest Loans | Cons of Simple Interest Loans |
| 1. Lower Overall Interest Cost: If you pay off the loan early or make extra payments, you can significantly reduce the total interest paid, as interest is calculated only on the remaining principal balance. | 1. Daily Interest Accumulation: Interest accrues daily on the principal balance, which can add up quickly if payments are missed or delayed. |
| 2. Transparency in Calculation: The method of calculating interest is straightforward – it’s based on the current principal balance, making it easier to understand and predict future payments. | 2. Potential for Higher Costs with Late Payments: Late payments can lead to higher interest costs since interest continues to accrue daily on the outstanding principal. |
| 3. Flexibility in Payments: Making additional payments towards the principal can reduce the total interest charges paid over the life of the loan, offering flexibility in managing the loan. | 3. Less Commonly Offered: Simple interest loans might not be as widely available as other types of loans, limiting your options. |
| 4. No Penalty for Early Payoff: Most simple interest loans do not have prepayment penalties, allowing borrowers to pay off their loans early without extra charges. | 4. Requires Regular Monitoring: Since interest charges accrue daily, borrowers need to be diligent about their payment schedule to avoid increased costs. |
| 5. Decreasing Interest Payments Over Time: As you pay down the principal, the portion of your payment going towards interest decreases, making later payments more effective in reducing the loan balance. | 5. Not Suitable for All Borrowers: Depending on individual financial situations, some borrowers may find other loan types with different interest structures more suitable. |
How Are Simple Interest Installment Loans Different From Compound and Precomputed Loans?
Now that you know the basics of simple interest installment 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 terms 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.
Frequently Asked Questions About Simple Interest Rates and Personal Loans
The monthly payment is primarily determined by the loan amount (principal), the interest rate, and the loan term. In a simple interest loan, the payment is calculated so that it gradually reduces the principal balance while covering the interest that accrues daily on that balance.
Typically, simple interest installment loans have a fixed interest rate, meaning it remains constant throughout the loan term. However, some loans might have a variable rate, so it’s important to clarify this with your lender.
In simple interest installment loans, interest accrues daily on the principal balance. However, you generally pay the interest along with part of the principal as part of your regular monthly payment.
In auto loans with simple interest, interest is calculated only on the principal balance. In contrast, compound interest loans calculate interest on both the principal and any accumulated interest, potentially making them more expensive over time.
The interest charges in a simple interest loan are calculated based on the current principal balance. As you pay down the principal, the portion of your payment going towards interest decreases.
Paying early can reduce the total interest you pay. Since interest accrues every day on the remaining principal, reducing that principal earlier than scheduled can lead to less interest accumulation.
Yes, paying more than the minimum required payment can save you money on interest. This is because extra payments reduce the principal balance faster, thus reducing the amount of interest that accrues.
If you miss a payment, interest will continue to accrue on the principal balance. This means your next payment will need to cover the missed interest plus the regular interest for the current period, potentially increasing the total cost of the loan.
The Annual Percentage Rate (APR) represents the yearly cost of the loan, including interest and any fees. It provides a comprehensive view of the loan’s cost, making it a crucial factor in comparing different loan offers.
Whether a compound interest loan is better than a simple interest installment loan depends on your specific financial situation and needs. Compound interest can accumulate faster, making it more expensive in the long run. However, it might offer other benefits or terms that are more suitable for certain borrowers.
Absolutely! When you pay more than the minimum required on your loan payment, you reduce the principal balance faster. Since you pay interest on the remaining principal, a smaller balance means you accrue less interest over time.
A Final Summary From CreditNinja on Simple Interest Loans
At CreditNinja, we think it’s important for borrowers to understand how loans work. If you’re thinking of taking out a loan, it’s essential to know that simple interest loans acquire interest daily in between payments.
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, such as a personal loan, you could be paying much more than you need!
Before taking out any loan, learn how to calculate interest on a loan to better understand the cost of borrowing. Check out the CreditNinja online blog for more information on interest rates, such as how to pay off a loan early to avoid interest charges.
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