Whenever you make a loan, you need to keep in mind that you will need to pay it off with interest. There is always a cost to borrowing money and it comes under the form of an interest rate on the amount you borrow.
However, there are two main types of interest and it’s useful to know how they work.
Simple vs compound interest
When you pay off a loan you could be paying either simple or compound interest. Simple interest is a percentage calculated only on the principal amount, meaning the initial sum of money you borrow.
Compound interest, on the other hand, will have you pay interest on the principal amount and the interest from the previous period. This means that you will be paying interest on your interest, making it harder to pay off a loan, especially if you’re only making your minimum monthly payments.
Loans with simple interest
Whenever making a loan, it is ideal to find one with simple interest to avoid paying large amounts in interest if it takes longer to pay it off.
The following loans can have simple interest:
- Car loans: most car loans have a simple interest. This means that your interest will be calculated on the amount of the loan on a daily basis. You will end up paying equal monthly payments, however in the beginning a bigger part of your monthly payment will go towards the interest in order to pay the interest first and then the principal.
- Some student loans: some student loans have what is called a Simplified Daily Interest Formula where the interest is calculated on the balance
- Some mortgages: many mortgages have a simple interest, however, you need to pay attention to how the interest is accrued, either daily or monthly. If the interest is accrued daily, it’s a simple interest loan. If it is monthly, it could allow negative amortization therefore it wouldn’t be a simple interest loan.
- Personal loans: most short-term loans like personal loans will have a simple interest
Loans with compound interest
- Credit cards: usually credit cards charge compound interest daily making it very easy to end up paying huge amounts of money in interest if you don’t always pay your balance in full. To avoid paying a lot of interest on credit cards, it’s important to pay the full amount before the payment due date.
- Some student loans: if you have a student loan with compound interest, you will pay interest on the principal and accrued but unpaid interest from the previous period.
- Mortgages with negative amortization: applicable on mortgages where the interest is accrued monthly. Whenever the loan payment for a specific period is less than the interest charged over that specific period, negative amortization is applied. This will increase the outstanding balance of the loan.
How to choose your loan
If you have the choice, choosing a loan with simple interest will allow you some peace of mind as you will only pay interest on the principal. It is useful to keep in mind that if you make late payments, you may still be charged extra fees.
However, when the option for simple interest is not available, for instance for credit cards, it’s useful to make sure to always pay the balance in full or make enough payments to cover the interest for that period to avoid paying interest on the interest accrued in the previous period and unpaid.