Let’s meet Zach…
Zach owns a t-shirt company, Zach’s T-Shirts LLC.
Business has been great—but he’s looking to expand so he can open a second location and bring on a few more employees! He’s researching his loan options — and he keeps seeing the terms amortizing loan and simple interest loan. Zach wants to know: “What’s the difference?”
Zach’s offered a 3-year amortizing loan of $100,000 with a 10% interest rate. After calculating, Zach sees he’ll repay his loan with monthly payments of $3226.72.
To understand how interest works, let’s take a look at Zach’s first two loan payments.
His 1st payment is 1 month after taking the loan.
His original outstanding balance he owes to the bank is $100,000.
And, as we said earlier, each monthly payment will be $3226.72.
But what portion of these payments go towards interest (what he’s paying to borrow the money) and how much goes towards principal (the money he actually borrowed)?
To find out, multiply the $100,000 balance owed to the bank by the 10% interest rate. You then divide the number of payments per year, 12, and get $833.33.
So his total payment is $3226.72. and we see that $2393.39 of the first payment is going towards principal and $833.33 is going towards interest.
Now let’s look at the 2nd payment.
2 months after taking the loan.
After his 1st payment, Zach still owes his bank $97606.61 in principal.
His 2nd payment, like all his payments, is $3226.72. We multiply the balance he still owes the bank $97606.61 x 10% (the interest rate). Then we divide by the number of payments (12) and get $813.38.
So for payment 2, his total payment is $3226.72. And $2413.34 is going towards principal while $813.38 is going towards interest.
You might have noticed that on the 2nd payment, he paid less to interest than on his first payment. Why is that?
Well, with a traditional amortizing loan, as you make more payments, there is less principal outstanding. So while your payment stays the same, you pay less towards interest on each payment.
Simple Interest Loan
Zach is offered a 6-month short-term loan of 100,000 with a factor rate of 1.2. So he’ll be required to pay back $120,000 in 6 months. The short term has daily payments, so for 22 days a month, Zach will make payments back on his loan. Each daily payment will be $909.09.
After 6 months and 22 payments a month, he’ll make 132 daily payments back on his loan.
So a daily payment of 909.09 times 132 payments = $120,000
So on each payment, Zach is paying $757.57 towards principal and $151.52 towards interest!
So with an amortizing loan, with each subsequent payment, you’ll pay more towards principal and less towards interest. And with a simple interest loan, with each payment, you’ll pay the same amount towards both principal and interest.
What does this mean for you?
An amortizing loan can be a good choice if you’re wanting a longer-term loan with lower payments. It will have a higher cost of capital.
A simple interest loan can be a good choice if you’re looking for a lower total cost of capital — meaning you’ll pay less in total money back — even though it may have higher APR and higher payments.
You should know, if you plan on paying your loan off early, this can adjust both the cost of the loan and can lead to prepayment penalties. You’re more likely to incur a prepayment penalty on a simple interest loan — as you’re paying the same amount to interest on every scheduled payment. Be sure to ask what happens!
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from Fundera Ledger https://www.fundera.com/blog/fundera-whiteboard-amortizing-vs-simple