There are two ways for a lender to charge interest on a loan, which are the simple interest and compound interest methods. Simple interest is calculated based solely on a percentage of the loaned amount, while compound interest is calculated based on a percentage of the loaned amount and interest. The higher the frequency of compounding, the higher the return will be for the lender. These variations in how the calculation is derived result in the following differences:
- Amount charged. The amount of interest charged is lower when simple interest is used, since this calculation does not include a charge for any interest outstanding. The amount charged when compounding is used can vary, depending on how frequently the compounding calculation occurs. For example, a loan that compounds daily will result in larger payments than an loan that only compounds semi-annually.
- Payoff. Since there is no charge for any interest outstanding, it is less expensive for the borrower to pay off a simple interest loan.
- Principal. The principal balance of a loan remains the same when simple interest is used, unless the loan balance is specifically paid down. The principal balance increases when compounding is used, since more interest is added to the loan, which may not be paid down by loan payments.