When you take out a loan or other type of financing, you must pay back the amount you borrowed plus interest. There are ways to avoid making interest payments, such as repaying the loan immediately, but most consumers require a payment period. There are two ways of calculating interest: compound interest and simple interest. Knowing the difference will help you determine your monthly payment. You’ll also be better equipped to determine if the financing offered is in your best interest.
Compound Interest Rate vs. Simple Interest: What’s the Difference?
Simple Interest Rate
As its name implies, this interest rate is simply a percentage of the principal. It’s the most basic way to calculate interest on a loan. The formula is easy to compute.
Simple interest = principal balance x interest rate x repayment periods
For example, if you borrow $5,000 with a simple interest rate of 7% and a repayment period of five years, you’ll pay a total of $1,750 in interest.
With simple interest financing, your principal balance doesn’t increase. Your monthly payment is predictable, and you can more easily create a debt-repayment strategy.
A simple interest loan is more affordable, depending on the amount you borrow, the interest rate you are offered, and your payment record. The faster you pay off your loan, the less interest you’ll pay. Maintaining a good credit score goes a long way to helping you secure the best interest rate.
Short-term loans, such as auto and personal loans, tend to use a simple interest rate formula to calculate your monthly payments.
In actuality, though, your interest rate is usually computed using a more complex procedure.
Compound Interest Rate
Compound interest rate financing is more intricate. There are many variables, including:
- Your interest rate
- Compounding frequency
- Initial loan amount
- Repayment period
The formula for compound interest is intimidating. While you can figure it out yourself, it’s much better to use an amortization calculator. The amortization chart is included in your financing offer, and you’ll want to review it carefully.
Compound interest is calculated not only on the principal but also on the accrued interest. The interest rate can be compounded daily, monthly, yearly, or other frequency.
If your financing terms are based on a compound interest rate, your monthly payment will change. Mortgages, student loans, and long-term personal loans are typically calculated using a compound interest rate formula. Credit card issuers usually provide an annual percentage rate (APR), but in reality, the interest is calculated daily. If you carry over a balance from month to month, the interest rate plus daily compounding can keep you in credit card debt for a long time.
Compound interest rates are favorable to investors. Simple interest rates are best for borrowers.
How to Avoid the Pain of Compound Interest Rates
- Compound interest grows the longer it takes to pay off your loan. Making additional payments each month toward your loan principal will help you save money on interest.
- Be aggressive about paying off credit card balances, student loans, and other types of financing.
- If you want to take out a new credit card, look for those that offer an introductory interest-free period. You’ll avoid compounding interest
- When comparing terms, look at the APY (annual percentage yield) rather than the APR. The APR is the simple interest rate, whereas the APY accounts for compounding. The longer it takes to pay off the loan, the more interest you’ll pay.
Before signing loan documents, carefully review all the information to understand how the interest is calculated. Whether a compound interest rate or simple interest rate, making extra payments toward your principal will reduce your interest payments.