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A simple interest loan is a loan in which the interest that is accumulated is calculated based solely on the original amount borrowed, an amount known as the principal. The total amount paid back from a simple interest loan would then be the principal amount borrowed plus any interest that has accrued over a certain amount of time. A simple interest loan is most commonly seen in regards to automobile loans, but it can be used in any type of loan situation.
In contrast to a simple interest loan, the compound interest loan is usually a more expensive option. A compound interest loan not only charges interest on the principal, it also charges any interest on previously accrued interest. For example, if someone borrowed $100 US dollars (USD) from a bank and was charged compound interest, interest would accrue over a period of time and at some point, further interest would be added. If the accumulated interest is $10 USD, then after a certain time period the amount calculated for interest would then be $110 USD, assuming nothing had been paid back during that time.
Simple interest loans would only charge interest based on the original $100 USD and would not include any other interest accrued. On a basic level, the simple interest loan is preferable, at least with regards to automobile loans. Housing loans work a bit differently, and simple loans are not always the best option.
For home loans, there are other loan options that actually come out cheaper due to the way the interest is calculated. In a standard mortgage loan, the interest is usually calculated on a monthly basis, whereas the simple loan interest is calculated on a daily basis. When added over time, more interest payment is made with the simple interest loan, assuming the percentage rate charged for interest on both loans is the same. The amount in difference increases the higher the percentage of interest charged.
There are other ways a simple interest loan can cost more. A common way this happens is with fees, either for paying the loan off early or for paying it late. For example, a standard house mortgage usually has a grace period to pay late, but interest is accrued daily in a simple interest loan, further interest accrues every day the payment is late.
Although not as common anymore, some loans will charge a fee for paying off the loan early. Some contracts for loans have it written in that a certain amount, usually an amount that was calculated to be the total money owed over a certain time period, has to be paid and if paid early, the amount would usually be less than the agreed upon amount. A fee for early payment, often rather large, is then charged. Most simple interest loans, unless the individual has bad credit, are not like this, but it always pays to read the fine print.
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