When you borrow money, you have to pay back the amount of the loan (called the principal), plus pay interest on the loan. Interest essentially amounts to the cost of borrowing the money – what you pay the lender for providing the loan – and it’s typically expressed as a percentage of the loan amount. You might be paying 3% interest on your car loan, for example, or 4% for your mortgage.
There are actually two different kinds of interest – and it pays to know the difference. Depending on the loan, you will pay either compound or simple interest. Compound interest is calculated on the principal amount plus the accumulated interest of the previous periods, which means you effectively pay interest on the interest. In contrast, simple interest is calculated on the principal only, so you don’t pay interest on the interest. Because you’re paying interest on a smaller amount of money (just the principal), simple interest can be advantageous when you borrow money. But do simple interest loans exist?
You’ll find simple interest loans offered by a variety of loan products, including car loans. With most car loans, interest is calculated on the principal loan balance on a daily basis, and payments are first applied to any interest due, and then towards the principal balance. The daily interest amount is equal to the annual rate (3%, for example) divided by the number of days in the year (365, except 366 during a leap year). So the daily interest on a loan balance of $10,000 at 3% interest would be $0.82 ($10,000 x 0.03 ÷ 365), assuming it’s not a leap year.
Like many loans, simple interest loans are typically paid back in equal, monthly installments that are established when you receive the loan. These loans are amortizing, meaning a portion of each payment goes to pay down interest, and the rest is applied to the loan balance. At the beginning of the loan, more of your monthly payment goes towards the interest since the interest is always calculated off the remaining balance, which is highest at the onset of the loan. As the loan term progresses, less of your payment goes towards interest and more applies to the principal.
If you have a $10,000 loan at 3% for three years, for example, your monthly payment would be $290.81. Twenty-five dollars of your first payment would go towards interest and the remaining $265.81 to the balance. The next month, $24.34 would go towards interest ($9,734.19 x 0.03 ÷ 12), and $266.48 to the balance, and so on until the loan and interest are paid in full. (If you are thinking of buying a car, see How Interest Rates Work on Car Loans.)
If you make all your payments on time each month, you should expect to pay back just the amount that is stated on your loan agreement. If you make a late payment, however, more of that payment will be used to pay the interest you owe because you’ll be paying more days of interest – and less will go towards reducing your principal balance. This adds interest to your loan, plus you may have to pay late fees.
Most student loans use what’s called the Simplified Daily Interest Formula, which is essentially a simple interest loan since interest is only calculated on the balance (and not on the previously accrued interest).
Most mortgages are also simple interest loans, although they can certainly feel like compound interest. In fact, all mortgages are simple interest except those that allow negative amortization. An important thing to pay attention to is how the interest accrues on the mortgage: either daily or monthly. If a mortgage accrues interest daily, it is always a simple interest loan; if it accrues monthly, it is simple interest unless it’s a negative amortization loan.
It’s important for borrowers to know how interest accrues on their mortgage since simple interest loans need to be managed differently than monthly accrual mortgages. One thing to watch out for: Late payments on a daily accrual loan can cost you dearly. If your payment is due on the first of the month, for example, and your payment is a week late, you’ll end up paying an extra seven days’ worth of interest. The grace period just allows you to avoid paying a late fee – not more interest. Since more of the payment goes towards interest, the late payment can actually make the loan balance go up instead of down. See What Are the Pros and Cons of a Simple Interest Mortgage? for more on this topic.
The Bottom Line
Simple interest loans calculate interest on the principal balance only, so you don’t end up paying interest on interest as you would with a compound interest loan. If you keep a balance on your credit card, you probably pay compound interest, and any interest charges are added to the principal – making your debt grow exponentially over time. Adding insult to injury is the fact that most cards compound interest on a daily – not monthly – basis, which can cost you even more over time.
Compound interest can sometimes work in your favor – just not when you borrow money. Here’s when: Simple and compound interest also apply to interest you earn when you invest money. But while simple interest can work to your advantage when you borrow money, it will end up costing you when you invest. Say you invest $10,000 at 5% interest paid once a year for 20 years. If your investment earns simple interest, you will have $20,000 – your original $10,000 + ($10,000 x 0.05 x 20) – after 20 years. If the investment earns compound interest, on the other hand, you will have $26,533 – your $10,000 + ($10,000 x (1 + 0.05/1)^20) – assuming interest is compounded one time per year. If it’s compounded 12 times a year, you’ll end up with even more – $27,126 in this case.
Dollar wise, you’re typically better off with simple interest any time you borrow – as long as you make payments on time and in full every month – and compound interest any time you invest.