When it comes to taking out a loan, there are two main types: simple interest and amortized interest. Simple interest is calculated only on the principal amount (the amount you borrow), while amortized interest is calculated on the principal and the accrued interest.
This can be confusing for many people, so in this blog post, we will compare simple interest vs. amortized interest and help you decide which option is best for you. Additionally, we will introduce the Infinite Banking concept and explain how you can borrow money from yourself with much better conditions!
What Is a Loan With Simple Interest?
Simple interest loans are a type of loan in which the interest charged is based only on the initial amount borrowed (the principal loan). The simple rate is usually lower than the annual percentage rate (APR) for other loans, such as credit cards and mortgages.
How Does Simple Interest Work?
With the simple loan, you pay interest calculated only on the principal. If you take from a borrower $100 at a simple interest rate of 20%, you will owe $120 after one year: the original $100 plus $20 in interest.
At the end of each year, the fixed interest rate is applied to the principal loan only, leading to accumulated interest. If you continue to make a month’s payment on the loan, the payment will increase each year.
How to Calculate Simple Interest?
You need to know three things: the principal balance (the amount of money you borrowed), the simple interest rate, and the length of time you will be repaying the loan.
The formula is:
I = Prt
I = interest
P = principal (the amount of money you borrowed from a lender)
r = simple interest rate (expressed as a decimal)
t = length of time (in years)
For example, let’s say you take out a $100 loan from a lender with a simple interest rate of 20%, and you plan to repay the loan over two years.
The formula would be:
I = $100 × 0.20 × ̅$100 × 0.20 × ̅
I = $40
You will pay $140 after two years: the original $100 plus $40.
What is Factor Rate?
Factor rates are simple interest rates expressed using decimal rather than percentages. So, if a simple interest rate is 20%, the factor rate would be 0.20.
To convert a factor rate to an APR, simply multiply the factor rate by the number of days in the year:
0.20 x 365 = 73%
Now that we know how simple interest mortgage works, let’s compare it to amortized one.
What Is a Loan With Amortized Interest?
An amortized loan is a type of loan in which the amount charged is based on both the initial amount borrowed and the accrued interest. Amortizing loans typically have a higher APR than simple interest loans, but they also have some advantages.
With an amortization schedule, you can evaluate loan terms and make comparisons when shopping for loans, break down your payments into an exact payment strategy, and compare them to your normal cash flow, giving you more control over the amount paid.
Loans may be amortized on a daily, weekly, or monthly basis. This means you’ll have to make payments every day or monthly or weekly payments until the due date. Interest compounds on amortizing loans, and your payment frequency will determine how quickly the interest accrues. Daily compounding occurs with loans that amortize daily and so on.
The interest on an amortizing loan begins at a high rate and will drop over time. This is due to the fact that, with each payment, you are only paying interest on the outstanding balance. As a result, your initial payment will include the highest charge since it’s based on the greatest loan sum.
The amount you pay each time affects how much money is repaid. It is firstly paid with the remaining balance, and as your loan’s term lengthens, the amount of money that goes toward its principal increases because you’re paying interest on a smaller loan sum. However, while the amounts paid toward interest and principal balance will vary from one payment to the next, you will pay the same amount throughout the loan term.
An amortizing loan’s periodic payments are applied to both the principal and interest, but not in equal amounts. In the early stages of repayment, most of each payment goes toward interest because that’s when the balance is highest. As time passes and you make more payments, the interest has a lower cost because the balance has decreased. This leaves more money to go toward the principal, and your periodic payments will reflect this change.
How Does Amortized Interest Work?
The loan amount is calculated on both the principal and the accrued interest. If you borrow $100 at an amortized interest rate of 20%, the payment applied will be $120 after one year: the original $100 plus $20.
The amortized interest rate is applied to both the principal and the accrued interest at the end of each year. This means that with every subsequent payment, the interest decreases compared to the first payment.
What Is the Difference Between Amortization and Compound Interest?
Amortization and compound interest are two different ways to calculate the interest on a loan amount.
Amortized interest is calculated on both the principal and the accrued interest. If you borrow $100 at an amortized interest rate of 20% from a lender, you will pay $120 after one year: the original $100 plus $20 in interest.
Compound interest is calculated differently. With a compound interest loan, it is applied to the principal and then compounded over time. If you take from lenders $100 at a compound rate of 20%, you will pay $120 after one year: the original $100 plus $20 in interest, which is then compounded.
Compound interest is typically used for long-term loans, for example, a home loan or mortgage. Amortized interest is typically used for shorter-term loans, such as auto loans.
How to Calculate Amortized Interest?
You need to know three things: the principal, the amortized interest rate, and the number of payments.
The formula is similar to the one from the previous example:
I = P × r (n/365)
I is the total interest charged
P is the loan’s principal
r is the annual rate
n is the number of days in the loan’s term
365 is the number of days in a year
For example, let’s say you borrow $100 at an amortized interest rate of 20% from a lender, and you make monthly payments. The number of payments would be 12 (one payment per month for 12 months).
Plugging those numbers into the formula, we get:
I = $100 × 0.20 (12/365)
I = $100 × 0.054794521
I = $54.79 in the amount paid over the life of the loan balance
It is simple to calculate, and more or less, the payment remains the same. Just remember to use the correct formula when you’re shopping for loans.
Paying Off an Amortized Loan
One of the benefits of amortizing loans is that you can typically make extra payments without penalty. This means that you can pay off the loan early and save on interest.
If you’re looking to pay off your amortizing loans and mortgage early, we recommend talking to lenders about your options. They may be able to help you make a plan that fits your unique circumstances.
Now that you know how simple and amortized interest work, which option is better for you?
What’s the Difference Between a Simple Interest Loan and an Amortized Loan?
The main difference between simple interest and amortized interest is how the interest is calculated. With simple interest loans, the interest is only applied to the principal, while with amortized interest, the interest is applied to both the principal and the accrued interest.
Another difference between simple interest and amortized loans is that simple interest loans typically have a lower APR than amortized loans. However, with amortizing loans, the second payment will be lower than the first month’s payment.
How to Choose Between a Simple Interest vs. an Amortization Loan?
Now that we’ve explained the difference between simple interest and amortized interest, let’s talk about choosing between the two.
There are a few things you should consider when making this decision:
- The length of loan term: Simple interest loans are typically short-term loans. If you’re looking for a long-term loan, an amortized loan may be a better option.
- The interest rate: Amortized loans typically have a higher interest rate than simple interest loans. This means that you’ll end up paying more in interest during the loan agreement for the same loan balance.
- Your ability to make extra payments: With an amortized loan, you can typically make extra payments without penalty. This means that you can pay off the loan early and save on interest.
Which Type of Loan Is Better for You?
The answer to this question depends on your individual circumstances. If you are looking for a loan with a lower APR, a simple interest loan may be better. However, if you are looking for a long-term loan or the ability to make extra payments without penalty, then an amortized loan may be the better choice.
For example, let’s say you’re considering a $100,000 loan with a simple interest rate of 20% and an amortized interest rate of 25%. The simple interest loan would have a monthly payment of $833.33 for 60 months, totaling $50,000. The amortizing loan payments would be $893.75/month for 60 months, totaling $53,625 in interest over the life of the loan.
While the simple loan has a lower monthly payment, leading to higher interest charges. On the other hand, the amortized interest loan has a higher monthly payment, but you’ll save money on interest in the long run.
If you’re deciding between a simple loan and an amortized interest loan, it’s essential to consider your financial goals and needs.
If you’re still unsure which type of loan is right for you, we recommend talking to a financial advisor. They can help you understand your options and make the best decision for your unique situation.
Alternative – Introduction to Infinite Banking
What if we told you there are other home and business loan options without worrying about interest rates or penalties after the grace period? That’s right, you’ve read it well.
Let us introduce the concept of over-funded life insurance.
Over-funded life insurance or Infinite Banking is a system where you are the bank and have complete control over cash flow. You borrow money from yourself at an interest rate that you set and pay back yourself. And because you’re the bank, there are no credit checks or need for other loans.
The best part? The interest you pay goes back into your policy, and over time, your policy’s cash value grows. This means that you can continue to borrow money from yourself without worrying about interest rates.
If you’re looking for a way to get loans without worrying about interest rates or how much you have paid in the previous periods, Infinite Banking may be the right choice for you.
So, which type of interest is best for you? If you want to keep things simple (no pun intended), go with a simple interest mortgage. However, if you are looking for a lower cost and to save some money in the long run, amortized interest is the way to go.
And don’t forget about Infinite Banking – it could be an excellent solution for your personal finance needs! If you are interested in learning more, we invite you to watch our free masterclass on building your private family bank around your lifestyle.
We are happy to welcome you to our community and support you on your financial journey!