Simple interest exists in most short-term loans. such as a car loan. The payment calculation varies from a compound interest loan. Understanding the difference helps a borrower budget appropriately.
What Is Simple Interest?
Simple interest is calculated by multiplying the daily interest rate by the principle times the number of days elapsed between payments. Each payment made during a period initially goes toward that month’s interest, and the remaining amount goes toward the principal. In this way, interest does not compound. Conversely, compounding interest sees interest accrue on top of interest.
Simple interest = P x I x N
Additionally, the timing of the payment matters. Those who make payments before the last day of the pay period enjoy fewer interest payments and more toward the principal amount. For example, if a due date for payment is July 1, those who pay on July 1 pay the maximum interest before deducting the principal. Those who pay before July 1 pay less interest, decrease the principal by a larger amount.
Simple Interest Analysis
How is this relevant to consumers? First of all, this structure benefits those who pay their balance quickly. This supports the time value of money concept. Educated consumers are able to estimate the interest payments on loans before they decide to borrow. Also, using the simple interest formula, consumers estimate when they will make payments such that interest payments remain stable and tolerable to the borrower.
Additionally, without the simple interest calculation, consumers end up paying much more than anticipated on the loan. Late interest payments add up over time and present a situation where the consumer steps outside the anticipated budget of the loan.
Finally, before entering into a loan agreement, one needs to become familiar with the simple interest calculation. This holds true whether one is borrowing or lending. Interest is a part of our financial system, and those who understand its benefit, while those who do not end up losing money.