Imagine a loan that actually becomes cheaper as you repay it! That’s the magic of a simple interest loan. Unlike loans that keep stacking interest on interest, these loans calculate your interest charges based on the remaining principal amount. As you make payments, not only does your loan balance shrink but so does the interest you owe.
The best part? Simple interest loans don’t play the compounding game, so you won’t find yourself paying interest on your interest. That’s a win for your wallet. These loans often come with lower monthly payments and might just be the budget-friendly solution you’ve been searching for when you need to borrow money.
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. As of January 2024, the average personal loan interest rates for consumers with good credit (credit scores ranging from 690 to 719) are approximately 17%.
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. Projections are hypothetical and do not represent tax, investment or other financial advice.
Here’s one example.
For a $60,000 loan at 4% paid monthly for two years, you have to pay approximately $2,605.50 monthly.
The first month’s interest amount is around $200 ($60,000 x 4% x 1/12), and the remaining $2,405.50 represents principal payments.
By the second month, you only owe about $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 approximately $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 about $102. 2
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 accrued interest. 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 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.
1. Student loans
Most federal student loans, such as Direct Subsidized Loans and Direct PLUS Loans, use a simple interest method for calculating interest charges. These loans also feature fixed interest rates, meaning the rate remains constant throughout the loan’s duration.
Private student loans typically also use simple interest to determine borrowing costs. However, unlike federal loans, the interest rates on private loans can be either fixed or variable. Fixed rates stay the same over the life of the loan, while variable rates can fluctuate. Additionally, some private student loans may charge compound interest, which can result in higher total interest costs over time. Understanding the interest calculation method and rate type is crucial, particularly if you have multiple student loans.
2. Mortgages
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.
3. Car loans
Like mortgages, car loans typically use simple interest to calculate borrowing charges, not compound interest. Buying a new car is an expensive purchase, some people consider leasing (hyperlink the word leasing instead of “buying a new car”) their car instead. Paying interest only on the principal makes auto loans less costly because interest doesn’t earn interest. The overall cost of auto financing generally increases depending on the term of the loan.
If you choose a longer term, monthly repayments may be lower, but the interest amount likely increases.
4. Personal loans
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 attention 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.
MoneyLion can help you find personal loan offers based on your background and the info you provide. You can get matched with offers for up to $50,000 from top providers. You can compare rates, terms, and fees from different lenders and choose the best offer for you.
Benefits of simple interest loans
These loans offer some great benefits, making them an appealing choice for borrowers looking for transparency and financial flexibility.
1. Easy to understand
With these loans, the math is refreshingly simple. Your interest charges are calculated based on the remaining principal balance, making it easy for borrowers to grasp and plan for their repayments without hidden complexities or surprises.
2. Lower overall interest cost
One of the standout advantages of simple interest loans is their potential to save you money. As your loan balance decreases with each payment, so does the amount of interest you owe. Over the life of the loan, you’re likely to pay less in interest compared to loans that compound frequently.
3. Predictable payments
Simple interest loans offer the comfort of predictable monthly payments. Knowing exactly how much you need to pay each month simplifies budgeting and financial planning, reducing the risk of unexpected financial strain.
4. Early repayment benefits
These loans reward proactive borrowers. If you decide to make extra payments or pay off your simple interest loan ahead of schedule, you can save even more on interest. The flexibility to accelerate your repayment timeline can be a significant financial advantage.
5. Accessibility
Simple interest loans are widely available, making them accessible to a broad range of borrowers. Whether you’re seeking a personal loan, auto loan, or even a mortgage, simple interest options are often on the table, allowing you to tailor your borrowing to your needs and financial situation.
Potential drawbacks of simple interest rate loans
Before deciding to commit to a simple interest loan, familiarize yourself with some of the potential drawbacks, including:
1. Limited loan term options
One of the potential drawbacks of simple interest rate loans is their limited range of loan term options. Unlike some other types of loans that offer various term lengths, simple interest loans often come with fixed terms under three years. This lack of flexibility can be challenging if you’re seeking a loan with a specific repayment timeline that doesn’t align with the available options.
2. No interest rate reductions
Simple interest loans typically don’t offer reductions in interest rates, even with factors such as good credit or consistent on-time payments. Unlike other loan types where borrowers might refinance to obtain lower rates, simple interest loans generally maintain a consistent interest rate throughout the term of the loan. This consistency in the interest rate is due to the nature of how simple interest is calculated.
In a simple interest loan, the interest is calculated on the principal amount owed and does not change over the life of the loan. As you make regular payments, the principal decreases, which reduces the total interest assessed, but the rate itself remains fixed. This contrasts with other loan types, such as compound interest loans or loans with precomputed interest, where the interest might be recalculated or determined upfront, respectively.
For example, with precomputed interest loans, the total interest is calculated at the beginning of the loan term and added to the loan balance. This means that even if you pay off the loan early or make extra payments towards the principal, you won’t see the same reduction in interest charges that you would in a simple interest plan.
Compound interest loans, however, calculate interest on both the unpaid balance and previous unpaid interest charges, which can lead to increased overall costs compared to simple interest loans.
3. Limited compounding benefits
While the absence of compounding interest is a benefit for simple interest loans, it can also be seen as a drawback in specific scenarios. Borrowers who anticipate substantial decreases in their loan balance over time may miss out on the compounding interest benefits that other loans offer, where interest charges decrease more rapidly as the loan balance decreases.
Simplifying Borrowing With a Simple Interest Loan
Simple interest loans are a financial tool that holds tons of appeal, particularly for those seeking transparency, predictability, and affordability in their borrowing. These loans are a great option if you value straightforward terms, want to avoid the complexities of compound interest, and appreciate the ability to calculate your total interest cost with ease.
While they may not be suitable for every financial situation, simple interest loans undoubtedly offer a valuable alternative for borrowers who prioritize clarity and control in their lending arrangements. By considering your unique circumstances and financial goals, you can determine if a simple interest loan aligns with your needs and contributes to your path toward financial stability and success.
FAQ
Do simple interest loans have fixed or variable interest rates?
Simple interest loans typically come with fixed interest rates. This means that your interest rate remains constant throughout the life of the loan, providing you with predictability in your monthly payments.
How can I reduce the interest paid on a simple interest loan?
To reduce the interest paid on a simple interest loan, consider making additional principal payments. By paying more than the minimum required each month, you can shorten the loan term and decrease the overall interest cost.
Are simple interest loans suitable for long-term borrowing?
Simple interest loans are generally more suitable for short- to medium-term borrowing needs. While they can be used for longer-term loans, such as car loans, they may not be the most cost-effective option for very long-term financing, such as a mortgage.
