When you shop around for a loan, you’re likely to come across two different options: simple interest loans and compound interest loans. While simple interest only accumulates on the principal balance, compound interest accrues on both the principal and the interest that’s already accumulated. Let’s take a closer look at the difference between simple interest loans and compounding interest loans so you can choose the ideal products for your unique situation.
What is simple interest?
Simple interest is solely based on the original principal balance of a loan, it doesn’t increase over time. This means, you’ll always know how much you’ll pay for the loan plus the fixed interest and be able to budget accordingly.
In many cases, simple interest is owed on traditional mortgages, car loans, and personal loans. Let’s say you borrow $2,000 and pay a simple interest rate of 3% for one year. You would pay back 3% of $2000 which would come out to $60 in simple interest.
What is compound interest?
Compound interest accounts for the principal plus interest that has already accumulated from previous periods. It’s often referred to as “interest on interest.” Some mortgages, personal loans, and student loans follow the compound interest model.
The higher the interest rate of a loan and the more frequently it compounds, the more interest you’ll pay in the long run. That being said, when you borrow money, compound interest will increase the overall cost of your loan.
Simple interest vs. compound interest: what’s the difference?
Compared to compound interest, simple interest is far easier to calculate and understand. If you take out a simple interest loan, you may only have to worry about the principal and the interest that accrues on that outstanding principal. You’ll likely enjoy lower payments and therefore increase your chances of paying off your loan as planned.
With a compound interest loan, however, you can expect higher monthly payments. If you’re on a tight budget or have other debt obligations, this type of loan may be problematic and lead to a serious cycle of debt. The good news is there are many simple interest loans on the market so you should be able to find a few options that work for your particular budget and needs.
Bottom line
Both simple and compound interest loans have their own advantages and disadvantages. Simple interest loans are typically easier to understand and provide a predictable repayment schedule. On the other hand, compound interest loans may offer a lower overall interest rate. Ultimately, the best type of loan for you will depend on your individual needs and circumstances.
Notice: Information provided in this article is for information purposes only and does not necessarily reflect the views of [publisher] or its employees. Please be sure to consult your financial advisor about your financial circumstances and options. This site may receive compensation from advertisers for links to third-party websites.
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