Amortization versus Simple Interest: What’s the difference?
- August 12, 2019
- By Aidan Dwyer
Choosing the right financing option for your business can be really difficult. There are hundreds of different lenders who will all offer you different types of financing. Which one is the best for your business? One of the most important factors to consider when choosing between financing options is the payback amount. Generally, loans fall into two categories of payback: Amortizing Loans and Simple Interest Loans. Below, we will discuss the differences between the two to help you decide which option is best for your business.
Amortized loans are loans that you can pay off over time. Merchants pay back the principal loan and the interest. The principal loan is the initial amount of money borrowed while the interest is the cost of borrowing the money. Payments are generally required on a daily, weekly, or monthly basis. To find out the cost of capital multiply the principal value of the loan by the interest rate. Then, divide the result by the number of paybacks in each year.
For example: if you take out $90,000 paid back monthly over a year at a 10% interest rate, you would find out that your monthly payback would be $8,250. During your first month’s payment, $7,500 would go towards your principal loan payback, and $750 would go towards interest. With a traditional amortizing loan, the payment amounts remain constant over the life of the balance. However, the amount of money that goes towards paying off interest decreases while the amount of money going towards the principal payback increases. The second monthly payment amount in our previous example is still $8,250, but because you have already made the first payment of $7,500 towards paying back the principal, the remaining balance on your loan is only $82,500.
Therefore, this means that less principal is left to multiply by the interest. When you recalculate your payment of $8,250, only $687.50 will go towards interest while $7,562.50 will go towards the principal payback. As the life of the loan goes on, you would see that in each payment, less money goes towards interest while more money goes towards principal payback. Nonetheless, the total value of each payment remains the same.
Simple interest loans are structurally different than amortizing loans. The amount of money going towards interest and principal payback remains the same for each payment. Simple interest loans are generally shorter in term length and are issued with a higher interest rate than amortizing loans. Since interest and principal payback amounts remain constant for each payment, you only need to know the interest rate, term length, payment frequency, and a total number of payments to figure out what portion of the payments will go towards each.
For example, if you get an 8-month loan for $50,000 at a factor rate of 1.3 with weekly payments. Then, you will have to pay back a total of $65,000 over 8 months. 8 months equates to 40 weeks, therefore you would have 40 total payments. To calculate the weekly payment amount you would need to divide $65,000 by 40 which comes out to payments of $1,625 each week. Of the $1,625, $1,137.50 would go towards your principal payback and $487.50 would go towards interest.
Which type of loan is best for your business?
While there is no right answer, both types of loans work differently. Amortizing loans entail longer terms and lower payments, but the total cost of capital is generally higher. On the other hand, simple interest loans have a lower cost of capital but generally mean shorter terms and higher APR on each payment. In addition, if you pay off a simple interest loan early, you are more likely to incur a prepayment penalty because the same amount of money goes towards interest on each payment.
REIL Capital can help you find the best financing options for your business. We offer custom-tailored financing and working capital packages with your business priorities in mind. If you want to find out more about our business financing options fill out our commitment free application to help us better understand how your business operates and allow one of our business financing representatives to come up with a business financing solution that best fits your business needs.