General Question

tedibear's avatar

Can a loan that charges a fee of any kind be considered a "simple interest" loan?

Asked by tedibear (16255 points ) January 8th, 2014

My understanding of a simple interest loan is that it is one that charges only interest and principal. There are no fees involved and repayment is only of principal and interest.

If a customer is charged a fee that is spread out over the life of the loan, then that loan is not a simple interest loan, and an APR is disclosed in the paperwork.

Am I thinking this through correctly? I’ve been in banking for a while now and this is what I remember being taught. I’ve been proofreading a document and I think they have the definition wrong.

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6 Answers

bolwerk's avatar

As I understand it, simple interest just ignores compounding. Like this:

FV = principle × interest × periods.

I would have thought compound interest is the conventional way to do a bank loan, using an ordinary annuity:

FV = C ([(1+r)^n-1]/r)
Where FV = future value, C = payment per period, r = interest rate, n = number of periods

Is the fee being discounted? What context is this for?

BosM's avatar

Yes it can. Interest methodology isn’t defined by fees charged on a loan. For example – Points on a mortgage loan can be charged upfront or spread over the life of the loan, typically at the borrowers preference. Points are typically used to “buy down” interest rates. So, fees can impact the effective interest rate percentage you end up paying.

There are different types of interest used to calculated payment due on a loan – simple or compound. Compounding interest is “interest on interest” and calculates interest when it’s added to the original principle amount. Conversely Simple interest is calculated on the original loan amount and not on accumulated interest.

jerv's avatar

My understanding of “simple interest loans” is the same as @bolwerk, and I have only ever seen it from sub-prime lenders that rarely have an APR of under 19%, often ones that disallow early payments.

However, like many things, the actual terms of the loan mean more than mere semantics. It’s less important what the actual definition of “simple interest” are or how closely the loan in question adheres to that definition than what the terms of the loan actually are.

tedibear's avatar

@bolwerk – Thank you for bringing up context. I hadn’t thought of it.

What I’m proofreading is a document that goes into a teller procedures manual. It doesn’t need any details about how the payments are determined, nor about compounding. The book currently refers to an installment loan as a simple interest loan. In my mind that isn’t quite right because we’re charging the $175 fee and it gets added to the loan. So the customer is really paying an APR of “X” percent, not just the interest rate of “Y” percent. To me, that doesn’t seem to be a simple interest loan. All I’m trying to do is make sure that we’re using the correct term in the book. I think that we should be using installment loan, not simple interest loan. (The book’s definition of mortgage loans is correct.)

jerv's avatar

If the loan is for $(X+175) and they only get $X from that loan in their hand, that’s different from loaning $X then charging a fee.

bolwerk's avatar

@tedibear: I’m not qualified to answer, but maybe whether it’s a fee or interest charged has tax implications for the borrower and/or the bank? Perhaps see if you know a CPA to ask.

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