Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
There are two types of interest on a loan: Simple interest and compound interest. Simple interest is calculated only on the principal amount, while compound interest accrues on both the principal and any previously accumulated interest, making it more expensive over time.Read on to find out how simple interest and compound interest work, the formulas for each, 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 or compound interest.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 date. Then, 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
Applying for a personal loan typically involves a few key steps:
Next, compare lenders to find the best terms and rates.
Gather necessary documents, such as proof of income and identification.
Submit an application online or in person.
Once approved, review the loan terms carefully before accepting, and receive your funds within a few days.
The Takeaway
Personal loans can come with simple interest or compound interest. The type of interest the loan has 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
LNTPL-Q125-050
About the Author
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.
