In this topic, we cover:
Most lenders charge interest on money borrowed, but how that interest is calculated can have an impact on your loan – and how you should manage the loan. One of the most common methods of calculating interest is called “daily simple interest,” in which loan interest is charged on a daily basis. Education, car and credit card loans often use the daily simple interest method.
With a daily simple interest loan, your annual interest rate is divided by the number of days in a year to yield a daily interest rate. At the end of each day, you’re charged interest for that day on the unpaid principal balance of your loan. Interest charges grow each day until you make a payment. Generally, your payment is first applied to the interest that has accrued since your last payment and then any remaining portion is applied to your principal balance, late charges, and other fees. Interest begins to grow again based on your daily interest rate and remaining unpaid principal balance. The process repeats until your loan is paid off.
Here’s an example:
If payments are missed or are consistently late, your loan repayment schedule can get off track because your principal balance does not decrease until you make your payment. Also, since interest is charged daily, delayed payments of any kind result in more days for interest to grow between payments – meaning more of each payment goes to interest. It could take longer to pay off your loan than originally scheduled and the total cost of repayment would be higher (in addition to any late payment fees and possible damage to your credit score).
If we revisit the $1,000 loan example, you can see that $0.33 of daily interest would come to around $10 over a typical month. If payments were missed for two months (that’s 60 days of interest growth), the interest would grow to around $20 plus any late fees. So even if you paid both missed months in a single payment, your interest will be greater than planned since the interest grew on a larger loan balance for a longer period of time. Since interest and (in some cases) other fees must be paid before any money is applied to the loan principal, your outstanding loan balance at the end of your loan term would be higher than planned. To get back on track for your original payoff or maturity date, a larger payment would be needed to reduce your loan balance by the same amount that was applied to cover higher interest charges and any associated fees.
In the same way that a one-time late payment adds additional days of interest, consistent late payments have the same effect. For example, payments that are consistently seven days late would add 84 days of additional interest in one year on a higher loan balance than planned in your payment schedule. To get back on track for the planned payoff date, a larger payment would be needed to reduce your loan balance by the same amount that was applied to cover the additional accrued interest charges.
Managing Simple Interest Loans
The best strategy for managing simple interest loans is to always make your payments on or before the due date each month. Otherwise, your loan will be more expensive, and will take longer to payoff, than you originally planned.
One strategy for ensuring timely payments is to set up automatic payments with your lender. On the designated date each month, the money is electronically withdrawn from your bank account. With no checks to mail or bills to lose, automatic payments are a great strategy. If you have trouble keeping your bank balance large enough to cover the automatic payment, ask your lender if it’s possible to schedule the payment to be closer to your payday or schedule the payment using online banking.
Further, depending on your loan and lender, it may even be possible to pay your monthly bill on a bi-weekly basis. This strategy means there are fewer days for interest to grow on your loan balance since the accrued interest is paid sooner and the remainder of the payment is applied to the loan principal. Depending on the size of your loan and the number of years of repayment, the savings from bi-weekly payments could be significant. If you think this strategy would be right for you, ask your lender if it is possible with your loan.