We often get customers asking us “should I do my loan with compound interest or simple interest?”. The answer is borrowers benefit from simple interest and lenders could benefit from compound interest. Often, the financial institutions do not give you a choice.
Interest can be charged in two ways, i.e. simple interest and compound interest. Simple interest - also known as US Rule - is when interest is charged only on the loan amount or principal balance. Compound interest - or Normal Amortization - is calculated on the amount of the loan plus any accumulated unpaid interest from previous periods. This unpaid interest gets capitalized into the balance, thus you have effectively “interest on interest.”
Many financial institutions use compound interest. If the borrower misses a payment or has deferred payments, the interest will be added to the balance so the next payment will include interest on the interest. Many states do not allow compounding so the law prevails and they can only offer simple interest loans. Most “friendly” loans between parties are simple interest, i.e. company or family loans. Simple interest loans also make the calculations simplistic.
There is no wrong or right method. If a loan is paid timely and there is no accumulated interest, both a simple interest loan and a compound interest loan will be exactly the same. The compounding only happens when there is unpaid interest. The compounding effect can make a big difference in the amount of interest payable on a loan if interest is not paid over a long period of time. That is what our friends at the IRS do for our taxes.
If you use TValue software, you can use either computation method. If you have questions on these methods, please feel free to call TValue Support at 800-426-4741.