You might think that interest calculation on a loan for a new home or car would be a simple matter of mathematics, but due to the many varied types of loan and interest programs, it's very possible for the same loan, for the same amount of money, to cost very different amounts under two different programs. Let's look at the difference between pre-calculated- and simple-interest loans.
As you might expect, simple interest is calculated simply, multiplying the interest rate of the loan by the principal on a regular basis to arrive at the interest due.
Pre-calculated Interest, on the other hand, calculates all interest payments for the entire length of the loan and adds those payments to the loan principal from the start.
The Difference in Dollars
Say you needed to borrow $10,000 for three years at a 10-percent interest rate. With a pre-calculated-interest loan, you could end up paying $13,000 over the length of the loan, since 10 percent per year is $1,000 times three years. On a simple-interest loan, since the principal of the loan decreases over time as you make payments, you would only pay about $11,500 over the entire length of the loan.
The ability to prepay principal and reduce future interest payments is another reason why simple-interest loans are superior. In most pre-calculated loans, prepayment has no effect on the interest, since all interest has already been totaled and added to your amount due. With a simple-interest loan, any prepayment of principal substantially reduces your future interest due.
Why Take Out a Pre-Calculated Interest Loan?
There is no good financial reason to make a pre-calculated-interest loan, unless it's the only kind of loan you qualify for. Pre-calculated-interest loans are most often offered by smaller, shadier lenders. Buyer beware: whatever you're borrowing money for, make sure to ask in advance how the interest is calculated.
An entrepreneur, author, and consultant, Jim Lemoine is currently a Fellow with TRI Leadership Resources, a global consulting, training, and management organization. He has written over 50 syndicated columns on a variety of topics including marketing and management, and has published a book, Business Defined. Lemoine holds an advanced degree from LSU and is a member of MENSA.