Loan Interest: Simple and Compound Interest Structures Compared

Trying to understand loan interest is something that a lot of consumers struggle with. If you are going to be an informed consumer, you need to understand exactly how they calculate it. Understanding the different methods that they use to calculate interest can help you avoid situations that you do not want to be in. The two main types of interest are simple interest and compound interest. Understanding the difference between them could potentially save you money in the long run and help you choose a loan that you are comfortable with. Here are a few things to understand about how simple and compound interest works.

Simple Interest

Simple interest is referred to as simple because it really is the least complex way to calculate interest. With simple interest, the formula for calculating it is I=Prt. "I" is interest, "P" is principal, "r" is rate and "t" is time. This means that in order to calculate the interest rate on a simple interest loan, you just take the principal balance times the interest rate and the amount of time.

For example, let's say that you had a simple interest loan for $1000 at 5% APR. In order to calculate the amount of interest that you are being charged, you would just take 1000 times 5%. In this case, the amount of interest that you are being charged is $50 per year. You could divide that $50 by 12 if you were making monthly payments and see how much you are paying per month in interest charges. If you have the option of getting a simple interest loan, you will usually want to take it as it results in less interest being charged over the long term.

Compound Interest

Compound interest is a little more complex. When you calculate compound interest, you are basically adding the interest amount in with the principal balance before you calculate the next period. This means that whoever is making the interest will potentially be making quite a bit more money than if they used simple interest. 

For example, let's say that you used the same loan from the first example except now it has compound interest. The first year of the loan, the lender made $50 in interest. The next year, they add that $50 to the loan balance and now the principal balance is $1050. Now they would take the 5% times the $1050 balance. This would give them an interest amount of $52.50 for the year. While it may not seem like much of an increase, over time, it can really add up. Compound interest is one of the most important things to understand if you are planning on investing or borrowing money. You need to understand the power of compound interest and make sure that it is working to your advantage. 

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