When a borrower takes out a loan, there’s a good chance they’ll be on the hook for interest charges. Interest, the price someone pays to borrow money, can be simple or compound. Compared to a compound interest loan, a simple interest loan is usually more affordable and easier to manage. Take a closer look below at simple interest loans and how they work. Lenders may not offer simple interest loans in certain states, and in some cases, an individual may be offered a pre-computed interest loan.)

What is simple interest?

Simple interest refers to an interest rate that will only apply to a loan’s original principal balance or the original amount of money a person borrows. It excludes any interest that has already accrued and doesn’t change over time.

Simple interest loans may include personal, auto, or student loans. If a borrower moves forward with one, they’ll enjoy a set amount of equal payments that are spread out over an agreed-upon term or time frame.

When someone makes an initial payment on a simple interest loan, that payment will cover the payment of the interest charge with the remainder applied to reduce the principal amount as long as that person has made payments on time.

Hence its name, simple interest is simple to calculate.  All someone has to do is multiply the interest rate by the principal and the loan duration in years. Say they take out a $1,000 personal loan with a simple interest rate of 5% and one year term. After a year, it would accrue $50 in interest. Keep in mind that any payments might exclude any additional fees an institution may charge.

Simple interest vs. compound interest

Simple interest is fixed and only charged on the loan principal annually, whereas compound interest is charged on both the principal and interest that has already accumulated. Compound interest may be fixed or variable and calculated daily, monthly, quarterly, or annually. A mortgage is an excellent example of a common compound interest loan. While simple interest is great for a borrower, compound interest is preferred for an investor.

Benefits of simple interest loans

With a simple interest loan, borrowers can enjoy a set payment amount over a specified time frame. If they make larger payments than they’re required to, they’ll lower their principal balance faster and save money as a result. They won’t have to pay “interest on interest” and may find it easier to pay off their loan early.

The bottom line

Compared to a compound interest loan, a simple interest loan is a breeze to manage. A simple interest loan is the way to go as long as a person has a steady income and the discipline to make flat monthly payments. Not only will they be able to budget for their payments in advance, but they may also pay off their loan earlier and save a lot of money on interest.

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