Search form

Content: 

TimeValue Software Blog

Simple vs Compound Interest for a Loan

By Martel Pellerin

 

Interest is defined as the cost of borrowing money. It can be either simple interest or compound interest. Simple interest is calculated on the principal amount of a loan only. Compound interest is calculated on the principal amount and also on any accumulated interest of previous periods that was not paid, and can thus be regarded as “interest on interest.” 

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 on unpaid interest. The compounding effect can make a big difference in the amount of interest payable on a loan if interest is not paid and is calculated on a compound rather than simple basis. 

So the next question is when would you use each method. Many financial institutions use compound interest as if the buyer misses interest payments they get the interest on interest. Many states do not allow this so the law prevails and they must do simple interest. Most friendly loans between parties are simple interest. There is no wrong or right method and once again if all interest payments are made timely, they will be exactly the same.