Simple Interest

Simple interest is a method of calculating interest earned or charged on a deposit or loan based on the principle amount only.

It is the most basic way of calculating interest and the one methods that most consumers would intuitively understand.

The irony is that most loan facilities and credit products don’t use simple interest to work out the interest due.

They are usually applied to auto loans and short term installment loans. Home loans are seldom, if ever, structured with simple interest.

Simple interest can be easiest to understand with an example.

For example, a 2-year personal loan of $5,000 might carry an annual simple interest of 6%. This works out to an interest expense of $300 per annum. However, if one want to calculate the interest on the loan after 10 months, maybe due to redemption, then the interest would be 6% x (10/12) x $5,000 which would work out to be $250.

If you try to apply this method on a regular mortgage, even if it a fixed rate loan, you wouldn’t be able to make any sense of it when compared to the actual payments on the account statement.

This is because such loan facilities are usually structured with a reducing balance method.

Sometimes certain types of products allow for simple interest to be calculated on a daily basis, maybe due to a change in payment due date. From the previous example, if interest needs to be calculated for 20 days, then the interest would be 6% x (20/365) x $5,000 = $16.44.

For term loans that have monthly debt obligations, each payment would go towards the repayment of the balance amount. The remainder would then be paid towards interest charges. No accrual would occur.

Simple interest vs compound interest

The concept of simple is often compared with compound interest.

Compound interest is basically the interest-on-interest methods of tabulating interest amount.

When comparing the two, the main difference is that simple interest would benefit a payer more, while compound interest would benefit the payee more.

To see how the two matches up in a savings deposit account, take a look at the table below.

$1,000 at 10%
End of first year $1,100 $1,100 NA
End of second year $1,200 $1,210 $10
End of third year $1,300 $1,331 $31
End of fourth year $1,400 $1,464.10 $64.10
End of fourth year $1,500 $1,610.51 $110.51

As can be observed in the table above, compounding interest generates a higher amount of interest compared to simple interest over time. And the difference grows proportional bigger and bigger with each period.

This is why when you are the borrower of a debt, having a simple interest loan would mean that you avoid the increasing interest charges as seen on compound interest facilities.

This assumes the the borrower would be making payments in full and on time as incurring late payment fees would only increase the total expenses paid for finance charges.

One reason being that if a borrower is 10 days late on a payment for example, then he would incur 10 additional days of interest charges. This is quietly added to the interest due. And when the payment is eventually paid, a portion would be paid towards the interest owed. Leaving a lesser amount to pay off the scheduled principle and interest repayment. The excess goes into the principle, and the borrower might not realize this until the end of the loan’s life.

If you are a depositor, compounding interest would enable you to earned much more interest over time.

The challenge is that finding such cumulative fixed deposits that have compound interest mechanisms built-in can be difficult.

And when they become available, banks might require a minimum deposit amount in order for a customer to enjoy the attractive interest rates.



Negative Amortization

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