What is a simple interest loan?

A simple interest loan calculates the interest based only on the principal you owe. It stands in contrast to a compound interest loan, which calculates interest based on principal and any outstanding interest charges. It’s important for you to know what to expect before you make the decision to borrow using a simple interest loan.

How does a simple interest loan work?

With a simple interest loan, it’s easy to calculate how much interest you will pay. All you need to know is the principal amount — the original amount you borrowed (or what’s left of it) — the interest rate and the length of the borrowing term.

A simple interest loan only charges interest on the amount of unpaid principal.

A simple interest rate like this could apply to many types of loans. It may be used on short-term loans, personal loans and some vehicle loans. Some mortgages also use simple interest. This type of loan is typically beneficial if you pay your loan on time or even early each month.

The formula for calculating simple interest is the following:

Principal x interest rate x time = interest due

Keep in mind that if you make extra payments on the loan, it reduces the principal balance and, therefore, reduces the amount of interest you will owe. This is a key benefit of a simple interest loan.

Simple interest loan example

To better understand how simple interest works, consider the following example:

You take out a $5,000 personal loan with a 6% interest rate and a three-year term with monthly payments.

In the first month, you can figure out how much you owe in interest by multiplying $5,000 by one-twelfth of a year by 6% annual interest, which comes out to $25.

Each month, the interest you owe is calculated again based on the decreasing amount of principal you owe. According to the loan amortization schedule, you will pay $152.11 per month, with the amount going toward interest decreasing over time.

The total amount of interest you pay over 36 months is $475.95, with a total paid to the lender of $5,475.95.

Simple interest loan pros and cons

There are both advantages and disadvantages to simple interest loans. Here is a look at some of the pros and cons you can expect.

Pros of simple interest loans

If you have a simple interest loan, you pay interest only on the principal you borrow — not on the principal plus interest. You can lower the amount of interest you pay — and shorten the loan term — by making extra payments toward the principal. Simple interest loans are also relatively easy to understand, as one person from South Carolina who wrote a review on our site pointed out about their personal loan.

Cons of simple interest loans

Making a late payment on a simple interest loan can result in significantly higher interest charges — on top of late fees and any other penalties your lender imposes.

Which loans use simple interest?

Many types of loans are simple interest loans. Here are some examples:

Short-term loans: Many short-term personal loans (those with repayment terms under three years) are simple interest loans.

Mortgages: Most mortgages are simple interest loans, with interest accruing daily or monthly. The exception: mortgages that use negative amortization.

Auto loans: Car loans generally use a simple interest calculation, with monthly payments amortized over a period of 24 to 84 months.

Simple interest loans vs. compound interest loans

A compound interest loan is different from a simple interest loan. With compounding, the lender calculates interest based on principal and any outstanding interest charges. A simple interest loan is based only on the principal amount of the loan.

One type of borrowing that uses compound interest is a credit card. Credit card companies charge interest on the principal amount you owe as well as any interest charges you carry when you don’t pay off your balance in full.

Simple interest loans vs. amortized loans

Many simple interest loans, such as personal loans, car loans and mortgages, use amortization. A portion of each monthly payment is applied to the principal while another part goes toward interest. As the loan term goes on, more of your monthly payment goes toward the principal because the amount of principal on which the interest is paid decreases. When taking out a loan, you can ask to see the amortization schedule, which shows you the principal and interest distribution of each of your monthly payments.

Bottom line

If you’re considering borrowing money, it’s important to understand not just the interest rate but also whether the lender is using simple interest or compound interest. Usually, a simple interest loan will cost less than a compound interest loan because the lender only charges interest on the principal — not “interest on the interest.”

A simple interest loan also tends to have fixed payments. You can reduce the amount of interest you pay on a simple interest loan by putting extra money toward principal — but you will also end up owing a higher amount if you don’t make payments on time.