Understanding how loans accrue interest can significantly impact your financial decisions and outcomes. Banks, credit unions, and other lenders use different methods to calculate interest, which can affect the total cost of your loan. Familiarizing yourself with these methods can help you make informed borrowing choices that align with your personal and professional financial goals.
Simple interest is calculated solely on the principal amount, ensuring straightforward and predictable interest costs. Compound interest includes interest on both the principal and previously accrued interest, leading to higher overall costs. While compound interest benefits investments, simple interest loans generally result in lower long-term costs for borrowers. BHG offers simple fixed-interest personal financing up to $200K1 with terms up to 10 years1,2.
Key Considerations
- Simple interest is calculated solely on the principal amount, ensuring straightforward and predictable interest costs.
- Compound interest includes interest on both the principal and previously accrued interest, leading to higher overall costs.
- While compound interest benefits investments, simple interest loans generally result in lower long-term costs for borrowers.
What is Simple Interest?
Lenders calculate simple interest based only on the amount you borrow: the principal. Typically, a loan’s simple interest rate is expressed as a percentage of the principal loan amount over time. While simple interest continues accruing until you’ve repaid a loan in full, the interest doesn’t build on itself. In fact, as you pay down your principal balance, simple interest charges decrease as well.
How is Simple Interest Calculated?
Three factors determine simple interest: principal balance, interest rate, and time.
Lenders often advertise loans’ annual interest rates. However, interest may build daily, weekly, or monthly. To calculate simple interest correctly, make sure the interest rate and timeframe line up: you don’t want to use the annual interest rate with a daily timeframe, for example.
The formula for determining simple interest is I = P*r*t.
- P is the principal loan amount.
- r is the annual interest rate, expressed in the form of a decimal.
- t is the loan’s term, in years.
Consider the following example.
Suppose you take out a $50,000 loan with a 4% interest rate and a 5-year term. In that case, you’d use the following formula to determine your total interest costs:
I = 50,000 * .04 * 5
I = 10,000
$10,000 would build up over the loan’s lifetime.
You could take the calculation a few steps further to determine the amount you’ll owe each month if your loan has fixed monthly payments. First, add your principal to your interest to find the total amount you’ll pay.
$50,000 + $10,000 = $60,000.
Then, multiply your loan term by 12 to find the number of months in your repayment period.
5 * 12 = 60.
Finally, divide the total amount you’ll pay by the months in your term to find your monthly payment.
$60,000 / 60 = $1,000
Your total monthly payment equals $1,000.
When is Simple Interest Used?
Lenders typically charge simple interest for most installment loan products, including:
While simple interest is the norm for installment loans, it’s not a given. Speak with your lender about interest before you commit to a loan product.
What is Compound Interest?
Unlike simple interest, compound interest grows based on both your principal balance and any interest that has accrued since your most recent payment. Interest may compound at different frequencies across lenders and financial products.
If your interest compounds daily, that means the sum of your principal and interest accrues more interest every day, incrementally increasing the amount that you owe. Loans with compound interest could quickly become difficult to manage, especially if you miss any payments. Carefully managing these loans is key to keeping debt under control. If you have high-interest debt, a debt consolidation loan could simplify the repayment process with better terms, including a fixed rate, a flexible repayment period, and one low monthly payment.1,2
How is Compound Interest Calculated?
Additional variables make the calculation for compound interest more complex than the formula for simple interest. To find compound interest, you need the principal balance, interest rate, and term, as well as the frequency at which interest compounds—whether that’s daily, weekly, monthly, or annually.
The formula for compound interest is A = P * (1 + r/n) n*t.
Breaking that down:
- A is the total balance owed over the lifetime of the loan, including interest.
- P is the principal loan amount.
- r is the annual interest rate, expressed in the form of a decimal.
- n is the number of times interest compounds within a year.
- t is the loan’s term, in years.
While compound interest is complicated, the formula offers insight into how interest works. Consider the previous example.
Say you take out a $50,000 loan with a 4% interest rate and a 5-year term. In this case, however, interest compounds daily. To find your total debt, including compound interest, you’d use the following formula:
A = 50,000 * (1 + .04/365)365*5
You can find the daily interest rate first:
.04/365 = .000109589
Then, find the exponent by multiplying the term by the number of times interest compounds in a year.
365 (days) * 5 (years) = 1,825
Now, you can plug those figures into your formula and use a calculator to solve the following calculation:
A = 50,000 * (1 + .000109589)1,825
The amount you ultimately end up with, including your principal balance and interest, is about $61,069. To find interest alone, subtract your principal from that number.
61,069 - 50,000 = 11,069.
So, you’d spend about $11,069 over the 5-year lifetime of a $50,000 loan with a 4% interest rate that compounds daily.
When is Compound Interest Used?
Some lenders may charge compound interest on certain installment loans. However, compound interest is more common for revolving debts. If you carry a balance on your credit card from month to month, small interest charges may compound daily. Depending on your card’s APR, these charges could add up quickly, making it more challenging to pay down your credit card debt.
To avoid mounting interest charges on revolving debts, try to pay your balance in full each repayment period. If you have an installment loan with compound interest, you may be able to minimize your interest fees by paying more than the monthly minimum.
Compound vs Simple Interest: Which is Better?
When it comes to retirement, brokerage, or high-yield savings accounts, compound interest enhances your money’s growth, generating better returns for you. However, as a borrower, you may prefer a loan with simple interest. If all the other terms are the same, you’ll spend less over the lifetime of a loan with simple interest than one with compound interest.
As you compare personal loan options, make sure you assess all the terms, not just the type of interest rate. Factors including the length of the repayment period, fees and penalties, application processing times, and monthly minimum payments may all influence your experience with a given loan and lender.
Flexible Personal Loans with Simple Interest Rates from BHG Financial
BHG Financial can help you reach your goals with personal loan offers tailored to your needs. Access up to $200,0001 for debt consolidation, home improvement projects, and more when you need it. Our personal loans come with fixed simple interest rates and extended repayment terms1,2 so you can keep your monthly payments to a minimum. That way, you can manage your loan without putting other financial goals on hold. To find the right fit, you can check your rate today in a few quick steps.
Simple Interest vs Compound Interest FAQs
What’s the difference between compounded interest and simple interest?
Compounded interest, or compound interest, builds on both the principal and the accrued interest of a loan or investment. Simple interest, on the other hand, accrues only on the principal amount. Simple interest doesn’t build on itself, but compound interest does.
What types of loans have compound interest?
Lenders may calculate interest using compound interest for any loan. However, compound interest is more common for revolving debt, like credit cards and lines of credit, than installment loans. Often, personal loans, mortgages, and auto loans come with simple interest rates.
