When you borrow money, you'll typically have to pay back more than you borrowed due to interest charges. Interest is the amount charged by a lender for the use of their money, and it's usually expressed as an annual percentage rate (APR). There are different types of interest loans available, each with its own features and benefits. In this blog post, we'll explore the key differences between simple interest loans (reducing balance), pre-computed loans (rule of 78 or actuarial), and amortized loans, and compare their pros and cons.
Simple Interest Loans (Reducing Balance)
Simple interest loans, also known as reducing balance loans, are loans where the interest is calculated based on the outstanding balance of the loan. As the borrower makes payments, the balance decreases, and the interest charges decrease accordingly. This means that the amount of interest paid each month is lower than the previous month, and the total interest paid over the life of the loan is less than that of other types of loans.
One advantage of simple interest loans is that they can be easier to understand than other types of loans. The borrower can calculate the interest charges using a simple formula, and the lender can provide a breakdown of the interest charges and principal payments on each statement. Simple interest loans are often used for short-term loans, such as payday loans or personal loans.
However, simple interest loans may not always be the best option. Because the interest is calculated on the outstanding balance, the borrower may end up paying more interest over the life of the loan if they make late payments or miss payments. Additionally, simple interest loans often have higher interest rates than other types of loans, which can make them more expensive in the long run.
Pre-Computed Loans (Rule of 78 or Actuarial)
Pre-computed loans, also known as add-on interest loans, are loans where the interest is calculated upfront and added to the loan amount. This means that the borrower pays the same amount of interest over the life of the loan, regardless of whether they pay the loan off early or late. Pre-computed loans can be structured using the Rule of 78 or the actuarial method.
The Rule of 78 method calculates interest charges based on the assumption that the borrower will repay the loan in equal monthly installments. The interest charges are front-loaded, so the borrower pays more interest in the early months of the loan than in the later months. This means that if the borrower pays the loan off early, they may not save much on interest charges.
The actuarial method calculates interest charges based on the borrower's outstanding balance each month. The interest charges are still front-loaded, but the amount of interest charged each month decreases as the balance decreases. This means that if the borrower pays the loan off early, they can save more on interest charges than with the Rule of 78 method.
One advantage of pre-computed loans is that they are predictable. The borrower knows exactly how much they will pay in interest over the life of the loan, and the lender can provide a breakdown of the payments and interest charges upfront. Pre-computed loans are often used for car loans or other types of secured loans.
However, pre-computed loans can be more expensive than other types of loans. Because the interest charges are added to the loan amount upfront, the borrower pays interest on the full loan amount, even if they pay the loan off early. Additionally, pre-computed loans often have higher interest rates than other types of loans, which can make them more expensive overall.
Amortized loans
Also known as installment loans, are loans where the borrower makes equal monthly payments over the life of the loan. Each payment includes both principal and interest, and the amount of interest charged each month decreases as the principal balance decreases. This means that the amount of interest paid each month is higher in the early months of the loan and decreases as the loan approaches maturity.
One advantage of amortized loans is that they provide a clear repayment schedule. The borrower knows exactly how much they need to pay each month and for how long, and the lender can provide a breakdown of the payments and interest charges on each statement. Amortized loans are often used for larger loans, such as mortgages or student loans.
Another advantage of amortized loans is that they can be more affordable than other types of loans. Because the interest charges are spread out over the life of the loan, the borrower may pay less interest overall than with other types of loans. Additionally, amortized loans often have lower interest rates than other types of loans, which can make them more affordable in the long run.
However, amortized loans can also have some drawbacks. If the borrower makes late payments or misses payments, they may be charged late fees or additional interest charges. Additionally, if the borrower pays the loan off early, they may be charged prepayment penalties. Finally, because the interest charges are spread out over the life of the loan, the borrower may end up paying more interest overall if they choose a longer loan term.
Which type of loan is the most common in the USA?
In the USA, the most common type of loan is an amortized loan. This is particularly true for mortgages, which are often structured as long-term amortized loans with 15- or 30-year terms. Student loans and personal loans are also often structured as amortized loans.
Simple interest loans and pre-computed loans are less common in the USA, although they may be used for short-term loans or loans with smaller loan amounts. For example, payday loans or car title loans may be structured as simple interest loans or pre-computed loans.
Conclusion
When choosing a loan, it's important to consider the type of loan and the interest rate, as well as other factors such as the loan term, fees, and repayment schedule. Simple interest loans, pre-computed loans, and amortized loans each have their own advantages and disadvantages, and the best type of loan will depend on the borrower's needs and financial situation. In general, amortized loans are the most common and affordable type of loan for larger loans, while simple interest loans and pre-computed loans may be more appropriate for shorter-term or smaller loans.
