What are simple interest loans?
A simple interest loan is a financing program that does not use the amortization formula to calculate monthly payments. Because the amortization formula sometimes can be confusing, simple interest loans may be easier-to-understand and calculate.
Two common types of simple interest financing are interest-only loans and lines of credit. But perhaps the most popular example of a simple interest financing program is the traditional credit card: borrowers are usually charged an interest fee each month based on the interest rate and the balance carried on the account.
How simple interest loans are structured
Simple interest loans can be structured in a variety of ways, including whether or not periodic or installment payments are used:
- No installment payments. Simple interest loans can be structured with no installment, periodic, or monthly payments. The interest due on the loan may be paid up front, deducted from the loan amount, or paid at the end of the term. There will also be a “balloon” payment to repay the original loan principal amount (unless the borrower has made extra payments to lower the principal).
- Interest-only payments. The popular interest-only financing program has low monthly payments, which only require payment for the monthly portion of the interest due. Unless the borrower makes extra payments to lower the principal, this loan will also require a “balloon” payment at the end of the term to cover the loan principal balance.
- Interest-only with some principal payments. This hybrid approach takes the interest-only payment and adds in a little more to lower the principal balance. Many credit cards use this approach with their minimum monthly payments: it covers the interest due, plus a very small percentage of the principal.
Comparing simple interest financing with amortized loans
To determine how much interest is due on a simple interest loan, borrowers can usually just multiply the loan amount by the interest rate. So a $10,000 simple interest loan with an interest rate of 10% would have an annual interest charge of $1,000. Divided by 12 months, that loan would have minimum monthly payments of $83.33.
With an amortized loan, the formula required to calculate monthly payments is more complicated. Most individuals need to use a financial calculator, online loan calculator or spreadsheet program to determine monthly payments.
The monthly payments on an amortized loan will also be higher – because the amortized payments also include payments toward the loan’s principal. However, because each payment reduces the principal a little more each month, the borrower on an amortized loan will pay less interest each month.
So from a simplicity standpoint, simple interest loans are definitely more convenient. But from a “cost of total interest charges” perspective, when comparing similar loans over several installments, amortized loans will actually end up costing the borrower much less.
The example amortization schedule below shows how the interest charges differ between simple interest and amortization for the same loan. In this case, this is a $10,000 loan with 10% interest and a term of 24 months:
Payment Number |
Amortized Loan Interest Charges |
Simple Loan Interest Charges |
1 |
$83.33 |
$83.33 |
2 |
$80.18 |
$83.33 |
3 |
$77.01 |
$83.33 |
4 |
$73.80 |
$83.33 |
5 |
$70.57 |
$83.33 |
6 |
$67.31 |
$83.33 |
7 |
$64.03 |
$83.33 |
8 |
$60.72 |
$83.33 |
9 |
$57.38 |
$83.33 |
10 |
$54.01 |
$83.33 |
11 |
$50.62 |
$83.33 |
12 |
$47.19 |
$83.33 |
13 |
$43.74 |
$83.33 |
14 |
$40.26 |
$83.33 |
15 |
$36.75 |
$83.33 |
16 |
$33.21 |
$83.33 |
17 |
$29.64 |
$83.33 |
18 |
$26.04 |
$83.33 |
19 |
$22.41 |
$83.33 |
20 |
$18.76 |
$83.33 |
21 |
$15.07 |
$83.33 |
22 |
$11.35 |
$83.33 |
23 |
$7.60 |
$83.33 |
24 |
$3.81 |
$83.33 |
Total: |
$1,074.79 |
$1,999.92 |
As shown above, the same loan may actually cost the borrower more over the long run. That is because the interest charges are based on the principal balance the borrower maintains on the loan. The higher the loan balance the borrower keeps over the long run, the more interest the borrower will have to pay.
The amortized loan is designed to reduce the principal balance continuously. Because each monthly payment lowers the principal balance, the borrower will owe less in interest charges each month.
The trade-off, unfortunately, is that amortized loans will have higher monthly payments. In the above example, the amortized loan will have monthly payments of $461.45 – compared to just $83.33 per month for the interest-only loan.
Borrowers choosing between amortized and simple interest loans will have to decide whether they want to save on total interest charges or keep their monthly payments lower.
Disclaimer: NetCredit is a direct personal loan provider and does not provide financial advice, nor does it vouch for any vendor or service mentioned on our NetCredit personal finance blog or online consumer loan glossary. Always research and perform due diligence on any service provider or vendor before deciding to use them, and we recommend that you speak with a financial advisor regarding all decisions that will affect your finances.