A simple-interest loan refers to a loan that calculates interest charges based on the remaining principal of the amount you borrowed. With each payment, the loan balance decreases and so does the interest portion of your loan.
Simple-interest loans are non-compounding, which means you won’t get charged interest on the interest. These loans may be less expensive and require lower monthly payments than loans that compound frequently. If you’re borrowing money, a simple-interest loan could be a practical choice, but it comes with some caveats.
Table of Contents
How does a simple-interest loan work?
What is a simple-interest loan? When you get a loan, you have to pay back the principal — the amount you borrowed — plus interest.
Lenders usually present interest as a percentage. For instance, some Small Business Administration (SBA) loans charge an interest rate of about 10.25%.
Interest represents the cost of borrowing, and there are two methods for calculating interest on loans — simple interest and compound interest.
With simple interest, you only have to pay interest on the remaining principal. Interest charges will not accrue on any unpaid interest from previous periods.
How to calculate interest on a simple-interest loan
Say you took out a $60,000 simple-interest loan at 4% with a two-year repayment period. Because it’s a simple-interest loan, you only have to pay 4% interest on the $60,000 you borrowed. Your 4% interest computation will change monthly based on the outstanding principal. Every payment you make against the principal decreases the interest portion of the monthly amortization on the next month.
Here’s one example.
For a $60,000 loan at 4% paid monthly for two years, you have to pay $2,605.50 monthly.
The first month’s interest amount is $200 ($60,000 x 4% x 1/12), and the remaining $2,405.50 represents principal payments.
By the second month, you only owe $57,594.50 ($60,000 less $2,405.50). After paying another amortization of $2,605.50, $191.98 ($57,594.50 x 4% x 1/12) goes to interest, while the remaining $2,413.52 goes to principal payments. On the third month, only $183.94 ($55,180.98 x 4% x 1/12) goes to interest.
If you continue paying your monthly amortization on time, by the 13th month, the interest portion of each repayment decreases to $102.
Simple-interest loans vs. compound interest
Compound interest is another method for determining how much interest you owe. Compared to simple interest, compound interest tends to be more costly for a borrower.
The basis for calculating compound interest is the unpaid portion of the principal plus any unpaid interest charges. As a result, you are paying interest on the interest portion of your loan.
With compound-interest loans, missing loan repayments is particularly expensive because loan balances to balloon over time. Credit card companies charge compound interest, so you end up paying more than what you borrowed if you can’t pay by the due date.
Types of simple-interest loans
Simple-interest loans are so common you may not have realized that your monthly loan payments use this method to calculate interest charges.
Most student loans, including federal loans like Direct Subsidized Loans and Direct PLUS Loans, charge simple interest. Federal student loans also have fixed interest rates that stay the same during the life of the loan.
Most private student loans use simple interest in calculating borrowing costs, but interest rates may be fixed or variable. Some private student loans charge compound interest which tends to increase the overall interest cost when getting a loan.
The simple-interest loan definition in reference to mortgages refers to a method of calculating interest daily. In this type of mortgage, the interest rate is divided by 365 days a year (366 for leap years). You can get the interest portion of the loan by multiplying the daily interest rate by the outstanding balance of your home loan.
Compared to a traditional mortgage, where companies charge interest rates monthly, the cost of a simple-interest mortgage tends to be slightly higher because it depends on the actual number of days in a month.
Like mortgages, car loans use simple interest to calculate borrowing charges, not compound interest. Buying a new car is an expensive purchase, so paying interest only on the principal makes auto loans less costly because interest doesn’t earn interest. The overall cost of auto financing increases depending on the term of the loan.
If you choose a longer term, monthly repayments may be lower, but the interest amount increases.
Some personal loans charge simple interest. When you’re short on cash, it makes sense to choose a simple-interest loan rather than a compound-interest loan. Pay extra care when reviewing loan terms and disclosures to know how the lender calculates interest rates and whether there are any add-on fees, other than interest, that could increase the total repayment costs.
Benefits of simple-interest loans
For most borrowers, simple-interest loans are the most cost-effective. Important benefits of this type of loan include:
- Potentially lower interest charges compared to compound-interest loans
- Borrowers only pay interest on the principal owed for a certain period
- Making principal payments reduces interest on the overall life of the loan
- Greater predictability because you pay a flat monthly payment
- Easier to manage and simpler interest calculation allows borrowers to verify the accuracy of interest charges on their own
Potential drawbacks of simple-interest rate loans
While there are many advantages in applying for a simple-interest-rate loan, there are disadvantages to consider such as:
- Getting approved for a simple-interest loan may be challenging.
- Making late payments on your loan can hurt your credit score and result in penalties and fees.
Because simple-interest loans only charge interest on the unpaid principal, it’s usual for lenders to charge late-payment fees and penalties when you can’t pay the loan on time.
Explore Better Loan Options
A simple-interest loan potentially has lower borrowing costs and is easier to manage than a compound-interest loan. But finding a lender that offers this type of loan can be hard, and making late payments on simple-interest loans can hurt your credit score. Understanding simple-interest loans is critical to paying them back on time.
Are car loans simple-interest loans?
Car loans charge simple interest, not compound interest, so they are simple-interest loans.
What does simple interest mean?
Simple interest for loans refers to interest computed based only on the unpaid principal.
Which loan is better simple or compound interest?
Simple-interest loans are better than compound-interest loans, with all else equal. The overall cost of borrowing for simple-interest loans tends to be lower.