Simple Interest vs Compound Interest: An Overview
When analyzing the terms of a loan, it is important to consider more than the interest rate. Two loans can have identical principal amounts, interest rates, and repayment terms, but significant differences in the amount of interest you pay, especially if one loan uses simple interest and the other uses interest. compounds.
Key points to remember
- Simple interest is calculated using only the principal balance of the loan in each period.
- With compound interest, interest per period is based on the principal balance more any unpaid interest already accrued. Compound interest over time.
- The Truth in Lending Act (TILA) requires lenders to disclose loan terms to potential borrowers, including the total dollar amount of interest to be repaid over the term of the loan and whether interest simply accrues or is compounded.
Simple interest is calculated using only the principal balance of the loan. Typically, simple interest paid or received over a period of time is a fixed percentage of the principal amount borrowed or lent. For example, suppose a student gets a simple interest loan to pay for one year of his tuition, which costs $18,000, and the annual interest rate on his loan is 6%. They repay their loan over three years.
The Truth in Lending Act (TILA) requires lenders to disclose loan terms to potential borrowers, including the total dollar amount of interest to be repaid over the term of the loan and whether interest simply accrues or is compounded.
With compound interest, the interest per period is based on the principal balance plus any unpaid interest already accrued. Compound interest over time. When calculating compound interest, the number of compounding periods makes a significant difference. Generally, the greater the number of compounding periods, the greater the amount of compound interest. Thus, for every $100 of a loan over a period of time, the amount of interest accrued at 10% per year will be less than the interest accrued at 5% semi-annually, which in turn will be less than the interest accrued at 2.5 %. quarterly.
In addition to scrutinizing the Truth in Lending declaration, a quick mathematical calculation tells you if you are considering simple or compound interest.
Compound interest leads to the “rule of 72,” a quick and useful formula commonly used to estimate the number of years it will take to double the money invested at a given annual rate of return.
Suppose you borrow $10,000 at an annual interest rate of 10%, with principal and interest due in a lump sum over three years. Using a simple interest calculation, 10% of the principal balance is added to your repayment amount in each of the three years. This amounts to $1,000 per year, which totals $3,000 in interest over the life of the loan. At the time of reimbursement, the amount owing is therefore $13,000.
Now suppose you take out the same loan, with the same terms, but the interest is compounded annually. The first year, the 10% interest rate is calculated only on the principal of $10,000. Once done, the total outstanding balance, principal plus interest, is $11,000. The difference is felt during the second year. Interest for that year is based on the full $11,000 you currently owe, rather than the principal balance of $10,000. At the end of the second year, you owe $12,100, which becomes the basis for calculating interest in the third year. When the loan matures, instead of owing $13,000, you owe $13,310. While you might not consider $310 a huge difference, this example is just a three-year loan; compound interest accumulates and becomes oppressive with longer loan terms.
Another factor to watch out for is how often interest is compounded. In the example above, it is once a year. However, if it is compounded more frequently, such as semi-annually, quarterly, or monthly, the difference between compound interest and simple interest increases. More frequent compounding means that the base from which new interest charges are calculated grows faster.
Another easy way to determine whether your loan uses simple or compound interest is to compare its interest rate to its annual percentage rate, which TILA also requires lenders to disclose.The Annual Percentage Rate (APR) converts your loan finance charge, which includes all interest and fees, into a simple interest rate. A substantial difference between the interest rate and the APR means one or two things: your loan uses compound interest or it includes high loan fees in addition to interest.
In real-world situations, compound interest is often a factor in business transactions, investments, and financial products intended to span multiple periods or years. Simple interest is mainly used for easy calculations: those generally for a single period or less than a year, although it also applies to open situations, such as credit card balances.
Take advantage of the magic of capitalization by investing regularly and increasing the frequency of your loan repayments. Familiarizing yourself with the basic concepts of simple and compound interest will help you make better financial decisions, save you thousands of dollars, and increase your net worth over time.