Compound vs. Simple: Which Loan is Better?
There are two kinds of interest you can encounter when taking out a loan: simple and compound. Not knowing the difference can end up costing you thousands of dollars over the life of a loan. Because Billshark is all about watching out for your money, we’re here to explain the two types.
What is ‘interest’?
When you borrow money from a bank or lending institution, you pay for the privilege (the interest on the loan).
When you lend money to your bank or lending institution (in, say, a savings account or certificate of deposit), then they pay you (the return on your investment, which is the interest earned).
Interest is calculated on the total amount owed (the principal), through either “simple” or “compound” methods.
Simple interest loans
Simple interest loans are just what they sound like: simple to calculate. The interest is determined by multiplying the daily interest rate by the principal (how much you still owe) by the number of days between payments.
The simple interest on a two-year loan of $10,000 at eight percent interest is calculated like this:
$10,000 x .08 x 2 = $1,600.
This means you will pay a total of $11,600 to the lender (principal plus interest).
These are necessarily simplified explanations to illustrate the difference between the two types of loans. In fact, the longer the loan term (that is, how long you have to pay it back), the less accurate a simple interest calculation will be.
With a simple interest loan, the bulk of each payment at the beginning of the loan goes toward paying off the interest, with lesser amounts going toward reducing the principal. This is because the interest is calculated on the remaining principal, which is highest at the beginning of the loan.
This is also why, when you check the balance on a car or home loan that you’ve been paying on for several months or even years, you may be surprised (and dismayed) at how much you still owe on the principal.
Compound interest loans
A compound interest loan factors in not only interest on the principal, but on all the previously accumulated interest. In other words, in these types of loans, you pay interest on the interest. With an investment, this is a good thing. It means that every dollar you make in interest is added to the total of your investment, and you make interest on the entire amount (that is, the principal plus interest becomes the new basis for earning interest).
But when you’re the one paying the interest on the interest, it’s not as advantageous to you.
The formula for calculating compound interest is algebraic, and not easily reproduced here. But there are numerous online calculators that will do the work for you.
Using the example above, $10,000 repaid over two years at eight percent compounded interest will ultimately cost $11,664.
Which is better?
Although it is clear that simple interest loans are cheaper in the long run. You may not have a choice. Most personal loans, including auto loans and mortgages, use simple interest.
Most credit card loans (that is, anything you charge on the card including cash advances) are compound interest loans and may be compounded daily. So if you carry a balance on your card, you’re paying interest on the interest. A good deal for the lender; not so much for you.
Wondering how much Billshark can save you on your bills? Check out our quick calculator to see how much you’re overpaying every month!