The beauty of a simple interest loan lies in the potential to reduce its overall cost by paying it off early. This is possible, because finance charges on a simple interest loan are applied only to the outstanding balance.
This is different than credit cards, for example, which compound interest charges. Interest is calculated based upon the outstanding balance, which is then is added to that balance. In other words, you pay interest on the interest charges.
Thus, saving money with a simple interest loan is simply a matter of paying off the loan before it runs its full term.
How a Simple Interest Loan Works
As we said above, simple interest is calculated only on the outstanding loan balance. Each payment you make decreases the balance and the interest charges fall commensurately. The more you reduce the balance, the less interest you will pay.
Let us say you take a $10,000 car loan at six percent interest with a $250 monthly payment. To calculate the interest payment, you will divide six percent by 12 months multiplied by the $10,000 loan amount. Thus, your first month’s interest payment will be $50 and the remaining $200 will go toward reducing the principal.
This will leave you with a balance of $9,800, which when you apply the formula again you’ll find $49 of the payment goes to interest and $201 goes toward reducing the principal.
In the world of finance, this is known as an amortizing loan. A portion of each payment reduces the outstanding loan amount, while the rest goes toward satisfying your interest obligation.
As you may have gathered from the example above, this can require some rather complex calculations to determine the full amount should the loan go to term. Fortunately, an online car loan calculator like the one offered by RoadLoans can do this math for you.
How to Reduce the Cost of a Simple Interest Loan
While there are a number of different strategies you can employ to make a simple interest loan a less costly proposition, they all boil down to the same thing: Pay early.
You want to repay the principal loan amount before the loan goes full term. Again, the sooner you repay the principal, the less interest you will encounter. Because the interest owed is calculated on a daily basis, if you always make your monthly payment before the due date, more of your money will go toward reducing the principal amount.
Paying more frequently has a similar effect. If you divide the monthly payment into bi-weekly installments, you will reduce the amount of interest charged each month and you’ll make 13 payments over the course of a year, rather than 12.
You can also pay more than contracted for each month. Adding extra money to each payment will reduce the principal amount more quickly, which, in turn, will shorten the term of the loan and reduce the amount of interest you will owe.
Whatever else you do, always pay on time. Otherwise, you will face late payment fees, which will increase the amount you will owe.
Lenders Benefit Too
Taken at face value, it might seem as if lenders get short changed when borrowers pay the loans off early. However, creditors are hoping you will pay them off early. That is part of the business model.
Simple interest loans earn more interest when they are young. When you pay it back early, that money can be put back into play with another borrower, earning the lender even more cash. In other words, saving money with simple interest loans is good for you and the lender too.