When it comes to financing, small business owners have two main options for loan structures: simple interest or amortized loans. But what exactly is the difference, and how do you know which is better for your company?
In this comprehensive guide, we’ll explain what simple interest and amortized loans are, how they work, key differences, pros and cons, and help you determine the best loan structure for your small business situation
What is a Simple Interest Loan?
A simple interest loan is a loan where interest is calculated only on the original principal balance. The interest rate stays the same over the life of the loan.
With a simple interest loan, your payments go towards both principal and interest. However, the interest portion stays the same while the principal portion increases over time as the balance decreases.
The formula for calculating simple interest is
Interest = Principal x Interest Rate x Term
For example, if you get a $100,000 loan at 8% interest for 2 years, the interest would be:
$100,000 x 0.08 x 2 = $16,000
Your monthly payments would be $4,333.33 ($16,000/12 months = $1,333.33 in interest per month + $3,000 principal per month)
What is an Amortized Loan?
An amortized loan is a loan where the payments are structured to pay off both principal and interest over a set term.
With amortized loans, the interest is calculated based on the outstanding principal balance. So as the balance goes down, less interest accrues each month.
In the beginning, more of your payment goes to interest. But by the end of the term, more goes to paying down the principal.
The amortization schedule breaks down exactly how much of your payment is principal vs. interest each month.
Using the same example above, a $100,000 loan at 8% interest amortized monthly over 2 years would have a monthly payment of $4,384.26.
Key Differences Between Simple Interest and Amortized Loans
While simple interest and amortized loans share some similarities, there are some important differences:
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Interest calculations – With simple interest, it’s based on the original principal only. With amortized interest, it’s based on the outstanding balance each month.
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Payments – For simple interest, the principal portion increases over time while interest stays the same. For amortized loans, principal and interest adjust each month.
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Interest paid – You pay more total interest with a simple interest loan over the full term. Amortized loans charge less interest overall.
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Loan term – Simple interest loans typically have shorter terms of 1-3 years. Amortized loans can have longer terms of 3-15+ years.
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Prepayment – Simple interest loans charge prepayment penalties. Amortized loans allow you to pay off early with no penalty.
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Qualifications – Simple interest loans have flexible approval requirements. Amortized loans have stricter requirements.
Pros and Cons of Simple Interest Loans
Pros
- Lower monthly payments
- Faster approval and funding
- Flexible qualifications
- No collateral required
Cons
- Shorter terms
- Prepayment penalties
- No interest savings for early payoff
- Higher total interest costs
Pros and Cons of Amortized Loans
Pros
- Longer terms and lower monthly payments
- Lower total interest costs
- Can pay off early with no penalty
- Interest savings if paid off faster
Cons
- Stricter approval requirements
- Slower funding times
- Collateral usually required
- Prepayment penalties on some loans
Which Loan Structure is Right for Your Small Business?
When deciding between simple interest vs amortized loans, consider these factors:
Loan Use
Simple interest loans are better for short-term needs like:
- Funding working capital or inventory
- Bridging cash flow gaps
- Covering short-term operating expenses
Amortized loans are better for long-term investments like:
- Purchasing equipment
- Business expansion
- Acquiring property
Loan Term
If you need financing for less than 2 years, a simple interest loan may be preferable. For longer terms of 3-10+ years, an amortized loan is likely the better option.
Early Repayment Goals
If you plan to pay off the loan early, an amortized loan allows you to save on interest costs. Simple interest loans charge prepayment penalties.
Qualifications
Startups or newer businesses may only qualify for simple interest loans at first until they build business history and credit. More established businesses can likely qualify for amortized loans.
Collateral
If you have business assets or real estate to use as collateral, an amortized secured loan provides better terms. Simple interest loans are typically unsecured.
Where Can I Get a Small Business Loan?
There are many potential lenders to consider for small business loans, including:
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Banks and Credit Unions: Offer both simple interest and amortized loan options but have stricter eligibility requirements.
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Online Lenders: Provide faster approvals and funding but primarily offer simple interest loans.
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Alternative Lenders: Finance companies that provide flexible qualifications but higher costs. Offer both simple and amortized loans.
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SBA Lenders: Banks and non-bank lenders that provide SBA-guaranteed loans, which are amortized with favorable long-term rates/terms.
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Lending Marketplaces: Allow you to complete one application form to receive offers from multiple lenders. Includes access to simple interest, amortized, and SBA loan options.
The Bottom Line
When it comes to choosing between simple interest vs amortized loans, consider your specific funding needs, qualifications, planned use of funds, and repayment timeline.
Simple interest loans provide accessible short-term financing but with higher long-term costs. Amortized loans offer better rates and terms for long-term investments but can be harder to qualify for.
Evaluate the pros and cons and work with an experienced lending partner to determine the best loan structure for your small business situation. With the right financing strategy, you can fund your business growth and set your company up for success.
Amortization vs. Simple Interest
The main difference between amortizing loans vs. simple interest loans is that the amount you pay toward interest decreases with each payment with an amortizing loan. With a simple interest loan, the amount of interest you pay per payment remains consistent throughout the length of the loan. Amortizing loans are more common with long-term loans, whereas short-term loans typically come with a simple interest rate.
If youâre in the market for a small business loan, youâre likely to encounter terms you might not be familiar with. One of the most common areas of confusion for novice business owners is amortization vs. simple interest loans.
The difference between amortization vs. simple interest lies in how you will pay back your loan. Itâs important to understand what each one means so you can pick a loan that makes the most sense for your specific business situation.
In this guide, weâll explain how amortizing and simple interest loans work, show you an example of both in action, and explain why you might want to go with one over the other. Letâs start with basic definitions of both amortizing and simple interest.
When it comes to loans, amortization refers to a loan youâll gradually pay off over time in accordance with a set scheduleâknown as an amortization schedule. An amortization schedule shows you exactly how the terms of your loan affect the pay-down process, so you can see what youâll owe and when youâll owe it.
With an amortization schedule, you can compare payment schedules when youâre shopping for loans, break down your payments into an exact payment plan, and compare that payment schedule to your regular cash flow.
Loans can amortize on a daily, weekly, or monthly basis, meaning youâll either have to make payments every day, week, or month. With amortizing loans, interest typically compoundsâand your payment frequency will determine how often your interest compounds. Loans that amortize daily will have interest that compounds daily, loans that have weekly payments will have interest that compounds weekly, and so on and so forth.
Most importantly, amortizing loans start out with high interest payments that will gradually decrease over time. This is because with each payment youâre only paying interest on the remaining loan balance. So your first payment will feature the highest interest payment because youâre paying interest on the largest loan amount. With subsequent payments, an increasing amount of the payment will go toward the principal, since youâre paying interest on a smaller loan amount. Keep in mind, though, while the amounts you’re paying toward interest and principal will differ each time, the total of each payment will be the same throughout the life of the loan.
Now that we understand the basics of amortization, letâs see an amortizing loan in action. Letâs say youâre offered a three-year amortizing loan worth $100,000 with a 10% interest rate and monthly payments.Â
Once you do the math, youâll find that each monthly payment amounts to $3,226.72. If you multiply this number by 36 (the number of payments you will make on the loan), youâll get $116,161.92. This means youâre going to pay $16,161.92 in interest (assuming you donât pay off the loan early).
Because the loan is amortizing, your first handful of loan payments will pay off more of the interest than the principal. To find out how much youâll pay in interest, 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. This means that in your first loan payment, $2,393.39 is going toward the principal and $833.33 is going toward interest.
For the second payment, you now owe the bank $97,606.61 in principal. Youâll still pay $3,226,72, but this time youâll only pay $813.38 in interest, and $2,413.34 in principal. This is because $97,606.61 x 10% divided by 12 is $813.38.
By the time you reach the final payment, youâll only have to pay interest on $3,226.72, which is $26.88.
What Is Simple Interest?
At this point, weâve already talked quite a bit about interest. But as a refresher, interest rate is the percentage a lender charges a borrower (you) to borrow a sum of money. This interest rate is quoted as a percentage of the amount of money you borrow. As the borrower, the amount you pay in interest is the cost of debt. For the lender, the interest rate is considered the rate of return.
Based on the interest rate you’re quoted, you will pay back a portion of your loan plus interest and other fees in accordance with your repayment schedule (amortizing or otherwise).Â
Simple interest is a specific type of interest you may be quoted on your loan. The first thing to understand about simple interest is that itâs a fixed interest rate, meaning the interest rate you are quoted when you take out your loan remains the same throughout the life of the loan (as opposed to adjustable rates, which fluctuate with the Market Prime Rate).
Simple interest is called simple interest because it is the simplest expression of your interest rate. Simple interest is the interest youâll pay a lender in addition to the principal and is expressed as a percentage of the principal amount.
Hereâs the simple interest rate formula:
Simple Interest = Principal x Interest Rate x Duration of Loan (years)
In our previous example of an amortizing loan, the simple interest rate was 10%, and the simple interest on the loan was $16,161.92.
Factor rate is a simple interest rate expressed as a decimal instead of a percentage. If your simple interest rate is 12%, then your factor rate is 1.12. So if you take out a $100,000 loan with a 1.12 factor rate, youâll repay $12,000 in interest because $100,000 multiplied by 1.2 = $12,000.
Letâs see an example of a loan with a simple interest rate to understand how it differs from an amortizing loan.Â
Say youâre offered a six-month short-term loan of $100,000 with a factor rate of 1.2. You can tell right away that the total loan amount youâll be required to pay back is $120,000 when you factor in interest.Â
This shorter-term loan has daily paymentsâ22 days out of every month. This amounts to a total of 132 payments over the six-month term. Divide $120,000 by 132 and youâre left with $909.09. This is the amount that youâll pay every day. To find out how much goes to principal and how much goes to interest, divide the principal and the interest by the number of payments youâre required to make.
When you do this, youâll find that $757.57 of every loan payment goes toward the principal ($100,000 / 132) and $151.51 of every payment goes toward interest ($20,000 / 132). Unlike amortizing loans, each simple interest loan payment will have the same amount go toward interest and the principal.
Amortization vs Simple Interest
What is the difference between an amortized loan and a simple loan?
Unlike an amortized loan, where the amount of interest owed fluctuates with each payment, simple interest is applied at the beginning of the loan and becomes the new loan balance. You then repay that in equal payments for the length of the loan. Say you borrowed $250,000 on an interest-only loan at an interest rate of 8%.
Should you amortize a loan or a simple interest loan?
Because of this, amortizing loans tend to have a higher cost of capital—you’re payments may be lower, but you make more of them so it winds up costing you more in the long run. Simple interest loans have a lower cost of capital—meaning you’ll pay less overall—but each individual payment will be higher and could strain your cash flow.
What is the difference between simple and amortized interest?
When it comes to taking out a loan, there are two main types: simple interest and amortized interest. Simple interest is calculated only on the principal amount (the amount you borrow), while amortized interest is calculated on the principal and the accrued interest.
Are amortizing loans a good idea?
Some amortizing loans will allow early repayment, thereby erasing any additional interest you’d otherwise have to pay. With a simple interest loan, you’re more likely to incur a prepayment penalty, as you’re paying the same amount to interest on every scheduled payment and the lender is counting on that money.