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Simple Interest vs. Compound Interest on a Loan

Do Loans Use Simple or Compound Interest?
Susan Guillory
Susan GuilloryUpdated January 31, 2023
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If you’re considering a personal loan, it’s wise to know and understand the different types of interest the loan might have. There’s simple interest vs. compound interest. The type of interest, and the way it’s calculated, affects how much interest you’ll pay on the loan overall. Read on to find out how simple interest and compound interest work, and how to know which type a loan has.

Simple vs. Compound Interest

Personal loan interest rates may be calculated in one of two ways: Simple interest refers to a percentage of the total amount you borrow. If you take out a one-year simple interest loan for $10,000, and the lender charges simple interest of 6%, you’ll pay $600 in interest over the repayment term of the loan.With a compound interest loan, the lender charges interest on both the principal and any outstanding interest that’s accrued. In the long run, you’ll pay more with a compound interest loan than with a simple interest loan.When comparing a personal loan from one lender to another, it’s important to understand these differences and know exactly what the loan involves. 

Simple vs. Compound Interest Formulas

Before taking out a personal loan, you can calculate how much you’ll pay in interest by using the loan’s maturity dateThen, find out whether the lender charges simple or compound interest for the loan, and use the corresponding formula below.

Simple Interest Formula 

To calculate simple interest, use this formula:P x R x TP = principal (the amount you borrow)R = rateT = time period (the length of the loan)

Compound Interest Formula 

For compound interest, the formula is more complicated:P(1 + R/N)NTP = principal (the amount you borrow)R = rateT = time periodN = compounding period (this is the period when interest kicks in)Every bank has a different compounding period for loans. It could be monthly, quarterly, or yearly. 

Simple Interest Example 

Here’s how simple interest would be calculated for a one-year loan of $10,000 at 6%. For the total amount of interest on the loan, the equation would be: $10,000 x .06 x 1 (year) = $600If you want to know how much interest you’d pay per month, this is called daily simple interest. To calculate it, you divide the interest rate (6%) by 365 (days in a year) to determine the daily interest charge:.06/365 = .0001644Then, take that number and plug it into the simple interest formula:10,000 x .0001644 x 30 (days of the month) = $49.32With simple interest, you’d pay $49.32 a month in interest.

Compound Interest Example

Now, here’s what this same loan would be calculated with compound interest, using a monthly compounding period, which is 12 periods per year:$10,000(1 + .06/12)12*1 = $616.78 By the end of the year, you would have paid $616.78 in interest. This is a little higher than the $600 you’d pay using the simple interest formula. It’s also important to note that the longer you take to pay off your loan, the more you’ll pay over time with compound interest.

How Do You Calculate Personal Loan Interest?

Whether you’re taking out a personal loan to remodel your home, pay for your wedding, or consolidate debt, it’s important to understand how much interest you’ll pay. First, determine whether it’s a simple interest loan or a compound interest loan, and then calculate the interest accordingly to see how much you’ll pay over the entire life of the loan.That way you’ll know exactly what the loan will cost you, and you can decide whether it’s worth it to borrow the money.

Add-on Interest Method

Certain types of loans, including short-term loans and payday loans, use the add-on interest method. With this type, the interest is calculated up front and added to the principal. As you pay off the loan over the designated time period, you’ll pay a flat rate of principal plus interest.However,  these types of loans tend to have higher interest and fees than more traditional loans.

Understanding How Regulation Z Works for You

Trying to decipher what type of interest a loan has and how much you’ll pay over time can be overwhelming. Fortunately, a law called Regulation Z, along with the Truth in Lending Act, is designed to inform and protect consumers. Thanks to this regulation, banks and lenders are required to disclose the following about loans:
  • interest rates 
  • any finance charges
  • monthly payment amounts
  • late fees
  • prepayment penalties
This helps ensure that you have the relevant information about the cost of borrowing money.However, it makes sense to still do your research and due diligence so you’ll know how much a loan will cost in interest and fees.

Applying for a Personal Loan 

Rates and terms for personal loans will vary from one lender to another. And the average personal loan interest rate a lender offers you will depend on your credit score, income, and debt-to-income ratio. Shop around for the best rates. This could save you hundreds of dollars or more in interest and fees. 

The Takeaway  

Personal loans can come with simple interest or compound interest. The type of interest the loan has, and how it’s calculated, impacts how much interest you’ll pay. Before taking out a loan, make sure you understand a loan’s rates, terms, conditions, and monthly payment amount.As you’re exploring personal loans, you’ll want to find one with the most beneficial rates and terms for you. By filling out just one application, Lantern by SoFi will give you offers from multiple lenders all at once. It’s quick, easy, and convenient.

Frequently Asked Questions

Are personal loans simple interest?
Are personal loans compounded daily?
What is simple interest vs compound interest for personal loans?
Photo credit: iStock/Prostock-Studio

About the Author

Susan Guillory

Susan Guillory

Su Guillory is a freelance business writer and expat coach. She’s written several business books and has been published on sites including Forbes, AllBusiness, and SoFi. She writes about business and personal credit, financial strategies, loans, and credit cards.
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