Knowing your loan's interest rate matters, as does learning how that rate is calculated. Interest is either simple or compound.
If you have a simple interest loan, interest is based only on the principal. You can easily calculate your interest using the principal, the interest rate and the loan term.
Compound interest, on the other hand, is interest on the principal, plus any interest that has accrued.
Simple interest loans can include auto and personal loans, mortgages, and some student loans. If you have any of these loans or plans to borrow, learning more about simple interest can help you understand the true cost.
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How Does Simple Interest for Loans Work?
A simple interest loan calculator is an easy way to run the numbers. But if you want to do the math yourself, here's how it works: Multiply the principal by the interest rate by the loan duration to get the interest.
Say you have a $10,000 car loan at 6% interest. Assuming a three-year repayment period, the total interest paid using the simple interest method would come to $1,800. That breaks down to $600 in interest paid each year.
If your loan term is less than one year, you use a slightly different formula to calculate simple interest.
"To calculate the amount of interest charged in a 30-day period, a daily interest rate would be computed by dividing the annual interest rate by 365," says Christopher Dervan, senior vice president of personal lending at PNC Bank. "The principal outstanding would be calculated for each day and multiplied by the daily interest rate to come up with a daily interest charge."
You'd then multiply the daily interest by 30 to get the total interest charged for that 30-day period.
Simple Interest Loans vs. Compound Interest Loans
Knowing whether a loan uses compound interest or simple interest is important. Each type can affect the total cost of borrowing differently.
"A simple interest loan means that the interest doesn't compound, meaning a customer won't be charged interest on the interest that is due," Dervan says. "Said another way, the principal balance used to calculate the interest due doesn't increase based on interest charges."
In other words, with a simple interest loan, you're not paying interest on the interest. With a compound interest loan, you are. Usually, a simple interest loan costs you less, depending on how much you borrow, the loan term, the interest rate and any fees.
You can calculate compound interest as well, but the formula is fairly complex compared with the one for simple interest. A compound interest calculator can handle this task.
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Advantages of Simple Interest Loans
Voss Graham, CEO and senior business advisor at InnerActive Consulting Group and former private financial consultant, says simple interest loans are the most cost-effective for borrowers.
"The benefits, in my opinion, are significant since you only pay interest on the principal you owe at any given time period," Graham says. "Plus, you can apply a specific principal payment without paying anything to interest accrued during the life of the loan, thus effectively reducing your interest owed quickly."
That's a plus for you but a disadvantage for lenders. Compound interest loans tend to be more profitable for banks because they may yield more interest from borrowers.
Simple interest loans also offer ease of use for borrowers compared with compound interest loans, Dervan says.
"They're often easier for customers to understand , and it's easier for them to perform their own calculations to verify that interest was charged correctly or how much they might have to pay under different scenarios," he says.
Simple interest loans have a flat monthly payment, so there's predictability with payoff as well. As long as you make your monthly payment on time, you'll pay off the loan according to schedule.
The main challenge with simple interest loans may simply be finding and getting approved for one. Graham says a strong relationship with a personal banker could help you get a simple interest loan. An excellent credit score could minimize your risk profile, he says, making you an even better loan candidate.
If you're planning to approach your bank about a mortgage, a car loan or another type of loan, be upfront about what you need and want.
"Don't be fearful of asking for the simple interest loan and stating that it's your preferred method of borrowing money," Graham says.
If the bank says no or doesn't make those types of loans, you can begin researching other options. You could check to see if credit unions or online lenders offer simple interest loans. Once you find lenders, look at the qualification requirements to gauge your odds of approval.
[Read: Best Private Student Loans.]
Look at the Entire Loan Picture
Before you sign off on any paperwork, read your loan documents carefully to understand how interest is calculated and note questions for the lender, Dervan says. Consider other characteristics of the loan beyond the interest structure, he says, such as:
-- Annual percentage rate
-- Nominal rate
-- Number of days to first payment
-- Monthly minimum payment
-- Loan repayment term
-- Maximum loan amount
-- Late and returned payment fees
-- Late payment policy
Graham says to ask the lender if borrowers can make extra principal payments on a simple interest loan and, if so, how those payments are applied. Ideally, extra principal payments would go straight to the principal, rather than the interest, allowing you to pay down the balance faster. In that scenario, you'd also want to know whether the lender charges a penalty for paying off a loan early.
Evaluating these factors together can help you see whether a simple interest loan is the right choice and what it may cost you.
"Customers shouldn't agree to anything they don't feel confident they understand," Dervan says. "The commitment to pay interest charges is an important component of that."
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