Amortized Loans vs Simple Interest Loans: Key Differences & Which Is Better for Your Business

When applying for a small business loan, you’ll likely come across two main types: amortized loans and simple interest loans. While both offer fixed interest rates and payments, there are some major differences between amortization vs simple interest that business owners must understand when choosing financing.

In this comprehensive guide we’ll explain everything you need to know about amortized and simple interest loans, including

• Definitions & examples of each loan type
• The key differences between amortization and simple interest
• The pros and cons of each type of loan
• How to determine if an amortized loan or simple interest loan is better for your business

What is an Amortized Loan?

An amortized loan is a loan that is gradually paid off over time through scheduled payments. With each payment, part of it goes towards paying interest while the remainder pays down the principal balance.

The amount of interest paid decreases with each payment while the amount going towards the principal increases. This happens because as the principal loan balance goes down you pay interest on a lower amount.

However, the total payment amount stays the same throughout the full repayment term. Amortized loans can have daily, weekly, or monthly payment schedules.

For example, let’s say you take out a $100,000 loan at 10% interest amortized over 5 years with monthly payments. Your monthly payment would be $2,024. The interest portion starts at $833 per month (10% of $100k ÷ 12 months) and decreases each month as the principal is paid down.

Meanwhile, the principal portion starts at $1,191 ($2,024 – $833) and gradually increases each month. After 5 years and 60 payments, the loan would be fully paid off.

What is a Simple Interest Loan?

A simple interest loan has interest calculated only on the original principal amount. The interest rate stays the same over the full loan term.

With simple interest loans, each payment is divided evenly between interest owed and principal owed. The interest portion does not change from payment to payment.

Simple interest loans often use factor rates, which are interest rates expressed as decimals instead of percentages. For example, a 1.10 factor rate equals a 10% interest rate (1.10 = 10%/100).

Let’s look at a simple interest loan example:

A business takes out a 6-month, $100,000 loan at a 1.2 factor rate (20% interest). The total repayment will be $120,000 ($100k principal + $20k interest).

With daily payments over 6 months (132 days), each payment would be $909.09. Of that, $757.57 goes towards principal and $151.51 goes to interest each day.

The principal and interest portions stay equal for each payment until the loan is fully paid.

Key Differences Between Amortization & Simple Interest

Now that you understand the basics of each loan structure, let’s look at some of the major differences between amortization vs simple interest:

• Payment Allocation – With amortization, the principal vs interest allocation changes with each payment. With simple interest, principal and interest portions remain equal throughout repayment.

• Interest Amount – Amortized loans have decreasing interest each payment as the balance declines. Simple interest loans have equal interest each payment based on the original principal.

• Interest Type – Amortized loans usually have compounding interest, while simple interest has (you guessed it) simple interest.

• Term Length – Amortized loans are generally medium or long-term (3-10+ years). Simple interest loans are normally short-term (under 3 years).

• Cost of Capital – The total interest paid over the full term is higher with amortization. But simple interest loans have higher payments, so they can be more challenging for cash flow.

• Prepayment – Amortized loans allow prepayment to reduce total interest costs. Simple interest loans often charge prepayment penalties.

• Collateral – Amortized business loans frequently require collateral like equipment or real estate. Simple interest loans are usually unsecured.

• Qualification – Getting approved for amortized financing is more difficult due to stricter eligibility requirements. Simple interest loans have more relaxed standards.

• Funding Time – The underwriting process for amortized loans takes more time. Simple interest loans can be funded in days or weeks.

Pros & Cons of Amortized Loans

Pros:

• Lower monthly payments
• Fixed interest rate
• Pay off loan faster by paying extra principal
• No prepayment penalties
• Usually lower APR

Cons:

• Require collateral
• More interest paid over full term
• Slower funding times
• Stricter qualification standards
• Early payoff not allowed with some lenders

Pros & Cons of Simple Interest Loans

Pros:

• Easier qualification requirements
• Faster funding times
• No collateral required
• Lower total interest costs
• Easier to calculate payments

Cons:

• Higher monthly payments
• Prepayment penalties common
• Limited flexibility on term length
• Higher effective interest rates
• Not ideal for large loan amounts

Which Type of Loan is Better For Your Business?

There are several factors that come into play when deciding if an amortized or simple interest loan is a better fit:

• Loan amount – Simple interest works better for smaller loan amounts. Amortization allows you to borrow larger amounts.

• Use of funds – Amortization is good for long-term investments like equipment purchases. Simple interest fits short-term needs like making payroll or covering expenses during slow seasons.

• Cash flow – If you need lower monthly payments, amortization may be better. Simple interest loans have larger payments that cover principal faster.

• Credit – Businesses with excellent credit scores have a better chance of qualifying for amortized loans. Startups or those with lower scores may need to opt for simple interest.

• Time in business – Lenders typically want 2+ years in business for amortized loans. Simple interest is more realistic for newer companies.

• Collateral – If you have assets to use as collateral, amortized loans allow larger amounts. Simple interest works for those without collateral.

Evaluate your specific situation, financing needs, and financial health to decide if simple interest or amortization better matches your small business loan requirements.

Frequently Asked Questions

Is amortization the same as compound interest?

No, they are not the same. Amortization refers to gradual loan repayment with a portion going to interest and principal.

Compound interest means interest gets added to the principal balance, so future interest accrues on that new balance amount.

Many amortized loans have compounding interest. But you can also have loans with simple interest that amortize.

Can I pay an amortized loan off early?

Most lenders allow early payoff of amortized business loans. This lets you save on interest by eliminating any future scheduled payments. Some lenders may limit prepayment or charge a penalty fee, so check loan terms closely.

Do simple interest loans build equity?

Simple interest loans do help businesses build equity, but not as efficiently as amortized loans. Part of each payment goes towards paying down principal to build equity in the financed asset or inject funds into the business. However, amortization allocates more of each payment to principal.

What is better for taxes, amortization or simple interest?

Amortization provides larger tax deductions, making it generally better for taxes. With amortized loans, interest payments are higher in the beginning when deductions have more impact. The interest deduction amount decreases over the term.

Simple interest loans have equal interest each payment, so the tax benefit does not change. The total interest write-off is also lower compared to amortized loans.

Can I get an amortized loan for a startup business?

It is possible, but very difficult. Most lenders want 2+ years in business before approving amortized small business loans. Startups are considered high risk, so lenders prefer offering them simple interest loans first. After building some history, a startup may qualify for amortized financing.

The Bottom Line

Amortized and simple interest loans each have pros and cons for small business owners. Amortization provides more affordable long-term financing, while simple interest offers fast short-term funding. Carefully assess your particular situation to choose the right loan structure for your needs. Be sure to compare all fees, terms and eligibility criteria as you shop different lenders to get the best rates and loan experience.