When looking for a small business loan, especially as a novice, you are likely to come into contact with new terms that can be confusing at first, such as the difference between simple interest loans and amortized loans. The key difference between these two is in how you will pay back the loan, so it is crucial to understand how both work so that you can choose which will be the best option for your specific financial situation.
To begin with the most basic definition, interest is the percentage of a loan that a lender charges a borrower to pay to commit to the loan. To the borrower, the percentage paid back in interest is referred to as the cost of debt. To the lender, this is considered the rate of return. Based on the interest rate agreed upon, the borrower pays back a portion of the loan plus interest along with other fees according to your repayment schedule.
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Simple Interest
Simple interest is a particular type of interest that you may use to pay back a loan. The key aspect to understand about simple interest is that it has a fixed interest, which means that the interest rate that you agreed upon when you first took out the loan continues to be the same during the entire period of paying off the loan. It is called simple interest because it is the most simple articulation of the interest rate. It is a percentage of the principal’s amount and is paid in addition to the principal at each payment.
Amortization
If you are utilizing amortization to pay off a loan, you’ll use an amortization schedule. This schedule will give you an exact picture of how the terms of the amortized loan will affect the resulting pay-down process so that you’ll know what you owe and when you owe it.
Interest compounds with amortizing loans, and the frequency of interest compounding will match with the frequency of your payments, whether that frequency is daily, weekly, or monthly. When shopping for loans, you can compare various amortization payment schedules to figure out an exact payment plan and schedule that will match your fixed cash flow.
While amortization looks a bit more complicated than simple interest in terms of the formula, the principle of the process is relatively straightforward. This repayment model employs varying amounts of principal and interest with every installment. This means that amortizing loans will require high-interest payments at the beginning but will decrease gradually over time. This decrease is due to the fact that at each payment, you’ll only pay interest on the outstanding amount left. The first payments will have you paying the highest interest payment along with the lowest principal amount. With the ensuing payments, you’ll begin to pay higher amounts on the principal and increasingly lower amounts on the interest payment.
However, keep in mind that even as you pay varying amounts on the principal and interest, that the total of all payments will be the same throughout the loan’s lifetime.
What are the key differences between Simple Interest and Amortization?
The main difference between simple interest and amortization is the differences in payment schedule and amount. While a simple interest loan requires paying the same amount towards the principal and interest at each payment, an amortized loan makes it so that you would pay more towards the principal and less towards the interest with each subsequent payment.
In addition, amortizing loans may have compounding interest, while simple interest loans keep to simple interest. This means that if your loan employs a simple interest rate, its interest is solely calculated on the principal sum. On the other hand, a compounding interest rate will mean that the interest is dependent on both the principal loan as well as on the accumulated interest. It also depends on the rate of payments, so that you’ll accrue more compound interest if you make more payments.
These differences lead to the final difference which is that simple interest loans tend to work better for short-term loan solutions while amortizing loans are usually utilized for longer-term loans. Due to this, amortizing loans may cost more in the long run but will allow you to make lower payments along the way. Simple interest loans, on the other hand, may cost less as a whole, but each payment will be higher and could be a larger strain on your fixed cash flow.
What is the best option for you?
With this information, you should now be more suitably equipped to figure out what kind of loan is best for your financial situation. Make sure to discuss loan terms with your lender. And if you are in the market for a faster option, a simple interest loan may be better. But if you are looking at a larger loan with longer terms for repayment that is less disruptive to your fixed cash flow, an amortized loan may be the better option.
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